GE/Honeywell case Economic theory

Industrial Organisation
GE/Honeywell case

Economic theory

There are two main points regarding conglomerate effects
1. Financial strength of GE capital
2. Bundling

Below I will set out these points in more detail. Relate the theory to the case, and give examples to help people understand.

Financial power
GE and GE capital have a very large market capitalisation share compared to Rolls Royce and Pratt and Whitney. Financial power allows a firm to engage more in risky investments in order to further the success of the firm, and this is because the firm I less likely to go bust the more financial power it has so it can make more investment mistakes. The ramifications for this for GE is that the firm can engage in risky R&D ventures that P&W and RR cannot afford to risk.
Financial power can be used to attract purchasers of goods, such that financial power can allow greater advertising and promotion which can increase the chances of sales. This means that GE can gain extra sales revenue over RR and P&W which could lead to a reduction in competition in the industry as GE may foreclose its competitors from the market.

Foreclosure
A firm that has greater financial power can essentially vertically integrate with more firms, and this allows the firm to get greater market control which allows it to restrict output and increase prices. For GE this means that the firm can vertically integrate with engine repairers, engine service firms, and replacement parts providers. This reduces competition as RR and P&W have to pay more than GE for engine servicing, repairs and replacement parts which could lead to foreclosure.

Bundling
Bundling is a way that firms can out compete competitors which leads to foreclosure. In an industry with specialist suppliers for the industry to be a success there must be demand across the industry for the specialised products. If a firm only sells one product and it is highly specialised a sudden negative demand shock would severely deprive the firm of profit and lead to foreclosure. A firm with a lot of market power can bundle two or more specialised products together and out compete rivals that can only offer un bundled single product versions. For GE and Honeywell this means that the firms can bundle engines and avionics together to the detriment of RR and P&W. Bundling can take several forms: Mixed bundling is where two or more products are sold together for less money than buying the products separately. Pure bundling is where two or more products are sold together and cannot be purchased separately, and technical bundling is where products in a bundle are not compatible with rival firms’ products. GE and Honeywell through bundling can effectively starve RR and P&W of revenue leading to their market foreclosure, which is worse for consumers in the end as it has an adverse effect on their welfare.

Conglomerate effects: Extending dominance
The Court of first instance (CFI) proposed that GE would extend market dominance into the market for Honeywell through the practice of bundling. I will explain a bit more about this below.

Bolton and Scharfstein (1990), proposed an economic model where financial contracts are observable and firms with deep pockets use financial power to weaken the performance of other firms. When a firm faces competition in many markets it invests heavily in risky R&D projects in the market with the fiercest competition in order to provide rivals with an incentive to stop innovation by cutting R&D funding.
In conglomerates the internal management must deicide upon the re-allocation across the subsidiaries in the merger. The management can decide to use a “winner picking” approach where the majority of funding is channelled towards the most successful firms. The other approach is to “cross subsidisation” which means spreading the funding across the subsidiary firms. This latter approach allows a wider presence to be maintained than the winner picking way as firms have more of a competitive presence across the participating markets. The “winner picking” approach may result in some firms being unable to compete and having to close.

Cestone and Fumagalli propose a winner takes all model of the product market. Firms with the most financial power can engage in R&D spending that smaller firms with less financial power cannot engage in with equal levels of effectiveness. In the model groups of firms compete with more strength than stand alone firms. Even if a stand alone firm spends the same as a group of firms on R&D the benefits will be less effective because it's a stand alone. This means that subsidiary firms related to the group are less likely to be effected by R&D investment made by rivals and so the stand alone firms are more inclined to exit the industry.
The merger would result in the conglomerate charging higher prices for after sales services, but the consumers are rational and can see that the overall cost of the engines and the after sales service for the engine is too high and would have an incentive to shop elsewhere for cheaper deals. Firms know that prices will go up if one conglomerate gains significant market power, the consumer firms realise this and so they have an incentive to promote the interests of rival firms. For the case this means that Boeing and Airbus are likely to want to buy from RR and P&W in order to keep competition alive for the purpose of driving industry prices down.

Theory of Leverage and relation to Kosher certification
The theory of leverage is that a firm can force foreclosure by chosing to buy supplies from the same firm all the time. In the case here it would mean that GECAS would decide to buy all of its engines from GE, and then from Honeywell post merger. When manufacturers decide what to produce they consider the preferences of 1% of the market, given that the 99% are indifferent between products. Kosher is when a Jew has to obey a specific diet by eating only Kosher foods. Kosher Jews prefer to buy Kosher certified foods and will never decide to buy non-Kosher certified foods. Manufacturers know the preferences of one percent of the market as being Kosher and so decide to offer Kosher certified products because the other 99% have no preference as they are indifferent.

The group of Kosher consumers are able to tip the market. Similarly in the case GECAS will only buy from GE, and post merger from Honeywell. GECAS considers a plane to be certified kosher only when all of the parts required to build the plane come from GE and Honeywell. If other buyers in the market have no preferences than there is foreclosure. This happens because suppliers in the industry e.g. airframe sellers know that if they don’t supply GE/Honeywell parts than they sacrifice all of GE/Honeywell business.