Dynamic Merger Policy and Pre-Merger Investment : Equilibrium Product Choice by an Entrant

We examine the effects of merger and merger policy on a potential entrant’s pre-merger investment incentives. We establish conditions under which the possibility of merger can induce an entrant to inefficiently imitate an incumbent’s product instead of innovating with a more differentiated product. Turning to policy, current practice is to evaluate a proposed merger by focusing on post-merger effects (e.g., whether the merged firm will charge higher prices or invest less in innovation than would the two firms if they remained independent of one another). We show that policies focused solely on a proposed merger’s ex post welfare effects can induce an entrant to choose an inefficient direction for its pre-merger investment, either because doing so maximizes the profits of a merger that would be approved regardless of the direction of its efforts, or because the nature of the approval process itself distorts incentives with respect to the direction of pre-merger investment