Mergers under endogenous minimum quality standard: a note

1 Introduction

The literature on minimum quality standard (MQS) has not considered the
possibility that firms merge. We extend the Bertrand triopoly model of Scarpa
(1998), by allowing mergers and an MQS as in Ecchia and Lambertini (1997).
Ecchia and Lambertini (1997) show that an MQS is welfare increasing, because
it makes price collusion more difficult. We show, instead, that when endogenous
horizontal mergers are allowed, an MQS becomes a welfare reducing device. This
is because the two highest quality firms merge and become a monopoly, with
the lowest quality firm exiting.

We add two initial stages to the timing in Scarpa (1998). In the first stage
the regulator chooses wether to introduce an MQS; in the second stage, firms
decide whether to merger; in the third and fourth stage, firms compete in quality
and price, respectively.

We first show that a merger between the lower quality firms, although reg-
ulated by an MQS, reduces both consumer surplus and welfare. This merger
shuts down the lowest quality firm and increases differentiation between the two
remaining qualities. All consumers are worse-off with the increase in aggregate
profit being larger than the reduction in consumer surplus. Then we show that
such a merger never occurs in equilibrium, because a merger between the two
higher quality firms is the most profitable. The two highest quality firms pre-
fer merging under an MQS because the regulated quality will be sufficiently
high to induce the lowest quality firm to exit the market. When an MQS is
introduced, the merger between the two highest quality firms would increases
both consumer surplus and welfare then it would be preferred by the regulator,
thought the lowest quality firm would gain a negative profit. However, it never
occurs in equilibrium because the low-quality firm exits after the announce of
an MQS. Since no bilateral merger involving the low-quality firm occurs, an
MQS induces the two high-quality firms to monopolize the market. On the
other hand, absent regulation a monopoly-merger among the three firms arises
and induces the same welfare and consumer surplus than the equilibrium under
an MQS. Our result is in line with Ecchia and Lambertini (1997). Both papers
study the effect of an MQS on an element, collusion in their case and horizontal
relations in ours, that is usually considered by the antitrust authorities compe-
tition reducing. Endogenizing the merging strategy allows us to show that an
MQS may reduce competition becomes a welfare reducing instrument.

2 The model

Scarpa (1998) considers a two-stage triopoly with vertically differentiated qual-
ities (qi, with i = 1, 2, 3 and q% < 7₂ < Qι)∙ Each firm supplies one quality and
each consumer consumes one product. Each firm i produces Xi. The costs are
^ci = ^^q'2 with profit π∖ = p_ix_i — Ci. Consumers are differentiated according
to their quality preference θ that is uniformly distributed over [0,1], with O_i be
the marginal consumer; that is, the lowest consumer type that buys quality i.

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