When Mergers Go Wrong

What do companies do when a merger turns out not to have been such a great idea after all? Research by Professor Steffen Huck and colleagues suggests that when corporate bosses find that their merger was bad for profits, they are likely to expand the firm's output aggressively to increase market share. And this seemingly irrational behaviour works: by committing themselves to high-output strategies, they can overcome their potentially loss-making position.

The study, which is published in the July 2007 issue of the Economic Journal, explores the so-called merger paradox, whereby the strategic consequences of a merger damage the merged firm. According to the paradox, while industry profits rise after a merger, the merged firm may suffer by losing market share.

Professor Huck and his colleagues find that this theoretical result does not always hold. In particular, when a firm''s leaders are used to a steady stream of profits, they tend to ignore the bad news once a merger, which in theory should lower their profits, has been implemented. They do this by committing themselves to very aggressive strategies.

While high-output strategies do not maximise short-run profits, they help the firm to maintain a superior market position in the long run. The researchers argue that this behaviour is driven by aspiration levels: ''If you are used
to a certain level of dividend, you simply hate the idea that you have to adjust to less money in the future, so you are willing to engage in more crazy aggressive behaviour.

Psychologically, it does not seem to be a viable option to tell shareholders, well, bad luck, we made a mistake, now we have to live with it. Rather firms resort to hardball tactics trying to maintain old profit levels.''

This behaviour has interesting consequences for merger activity. While no merger is planned to be unprofitable, the sheer announcement of a merger may signal to competitors that the merging firms are willing to engage in hyper-competitive actions. As Professor Huck notes, ''this may explain some of the merger crazes we observe in
industries where mergers don''t appear to be particularly appealing.''

On a more fundamental level, the study shows the importance of psychological effects for firm behaviour: ''There is now a growing body of research that looks at markets with psychologically challenged consumers and ultrasmart firms – what we shows is that it is time also to look more closely at boundedly rational decision-making in firms.''

"The Merger Paradox and why Aspiration Levels let it Fail in the Laboratory'' by Steffen Huck, Kai Konrad, Wieland Muller and Hans-Theo Normann is published in the July 2007 issue of the Economic Journal.