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A cacophony of watchwords kicks in whenever a big merger looms: Colossal. Consolidation. Competition.
The proposed merger of Raytheon Co. and United Technologies Corp. announced earlier this month is no exception. It’s the latest and largest deal in a wave of consolidation in the defense industry. The combined company would create the second largest aerospace and defense company, based on sales, after Boeing Co.
As the deal awaits government and shareholder approval, and concerns about decreased competition are in full swing, timely research led by Mark Duggan, the Trione Director of the Stanford Institute of Economic Policy Research (SIEPR), points to some potential effects.
Put plainly: When it comes to consolidation in the defense industry, bigger isn’t necessarily always better. But it’s not all evil either, according to his research.
The study — co-authored by Stanford doctoral candidate Rodrigo Carril — closely examined impacts on government contracts from increased consolidation in the defense industry between 1985 and 2001. It concluded that the buildup of mergers led to less-competitive bidding for defense contractors. But, at the same time, the two researchers did not find any evidence of a significant increase in acquisition costs for large weapon systems.
The authors embarked on the study, recognizing the rising concentration and the lack of empirical economic analysis in the defense procurement arena. Here, Duggan discusses merger tradeoffs in light of the Raytheon and United Technologies deal.
What’s at stake here?
Defense spending is a huge part of the federal budget. For U.S. taxpayers, we spend about $2,000 per person per year on our Department of Defense, or about $650 billion annually — and about half of that is procurement from defense contractors.
So there's a lot at stake here. This is not like a merger of two gas stations. This is really consequential, both from the point of view of taxpayers and for those serving in the military. If you have a merged entity that, for some reason, isn't producing at the same quality as one or both companies were previously, then that may be putting service men and women at risk.
Depending on who’s talking, the proposed merger sounds like it’ll be a fruitful marriage or bad news. Are worries about decreased competition warranted?
The defense industry is more concentrated now than it has been in decades, and this merger will make the industry even more concentrated.
In general, as industries become more concentrated, people like me and other economists tend to worry that it will lead to things that are bad for consumers – or in this case, the federal government and every U.S. taxpayer. One big concern is that they’ll mark prices higher, above their costs of production.
But on the plus side of mergers, bigger size may lead to greater efficiencies, and that may allow costs to fall. It’s difficult to predict which of these situations would dominate. Sometimes the efficiencies and improvements are so great that even if the merged companies can mark up somewhat more over costs, prices can still fall.
Your recent study looked specifically at how industry consolidation affects government contracts at the Department of Defense. What do your research findings suggest might happen with this proposed merger?
We looked at the effect of mergers of large defense contractors that happened in the 1990s, and assembled data on all contracts in the Department of Defense in the years leading up to, during, and following these mergers. Our strategy was to essentially see what things changed for products where the two companies were both big players, and what changed for products where only one was an important player, or where neither was a big player.
What we found is that — as a result of the mergers — the government became much more likely to forego competitive bidding for products where competition had lessened. There were more single-bid contracts. And that’s a problem as we think that at least some competition is needed to get the best possible outcome.
However, we did not find that prices or overall spending seem to have increased significantly.
It’s interesting you didn’t find evidence that increased industry concentration resulted in higher spending on defense products. What do you think are the reasons behind that?
This is in contrast to other research I've done in the past on the health insurance industry, where I found that when two big players merged in a market, prices went up significantly. In this study of Department of Defense contractors, it doesn't seem that prices went up by much.
It's very plausible that the merged firm is under heightened scrutiny by the government. And if they were to try to leverage their greater market power to raise prices, they would run into problems in getting future contracts.
Essentially, the government may have kept an especially close eye after these mergers so they wouldn’t get fleeced.
What do you think antitrust regulators should be looking at when they weigh whether or not to approve this merger?
Defense is a hard area because it's not like cars or air travel where you've got a lot of feedback from consumers about quality and price. In defense, every product is very different, so it's hard to make apples-to-apples comparisons over time.
Antitrust regulators should be vigilant when two defense companies want to merge, especially when they're two big players in an important category of products the military needs.
Regulators really need to get granular to see what United Technologies is producing and what Raytheon is producing. They need to isolate the products where we are concerned the merged company may get too much market power and maybe require one of them to divest in that area. To take an analogy, suppose that American and United Airlines wanted to merge, but they were the only two companies serving the San Francisco, CA-to-Dallas, Texas market. That would be a problem.
Also, they need to have some clarity on what the efficiency benefits would be. It's easy to say there are synergies and to say, ‘Bigger is better, and we're going to be more efficient.’ But regulators should look for concrete evidence of that.
The two companies are stressing that only a small portion of their businesses overlap.
It’s no surprise they’re zooming in on that, saying, ‘We don't compete. They make one thing, and we make something else.’ But regulators are going to have to figure out to what extent that is true.
The more evidence that it looks like it's a merger of two companies making different products rather than a merger of direct competitors, the more likely it is that the merger will get approved.