Elsevier

Resources Policy

Volume 29, Issues 3–4, September–December 2003, Pages 111-118
Resources Policy

What do economic simulations tell us? Recent mergers in the iron ore industry

https://doi.org/10.1016/j.resourpol.2004.06.005Get rights and content

Abstract

This paper investigates the European Commission's decision to allow a merger between two Brazilian iron ore mining companies, CVRD and Caemi, using data on the Direct Reduced Iron pellet market. By using a simulation model, we can directly simulate the total welfare effects from the merger and hence evaluate the merger from a new perspective. The results from our simulations suggest that the welfare effects are negative from the merger between CVRD and Caemi, which supports the conclusion drawn by the European Commission decision. By performing different simulations between hypothetical merger candidates, our results show that only mergers between small candidates have the potential to be welfare enhancing.

Introduction

During 2001, 1562 million US dollars were spent on mergers and acquisitions in the global iron ore mining industry; in 2002 and 2003 the figures were 2861 and 3959 million US dollars, respectively.2 From the global mining industry, the iron ore industry is one of the few industries that has experienced a continuous consolidation trend since the 1970s (Ericsson, 2001). Recent figures show that the iron ore industry is only moderately concentrated. The three largest firms control roughly 30% of the world production (Ericsson, 2004).

From society's perspective mergers can either have positive or negative effects. The direction of the effects depends on whether the predominant cause is to increase efficiency through cost reductions or alternatively increase market power. A combination of the two is also possible in which case the net effect is more difficult to foresee.

When assessing the economic impact, the public policy towards mergers—as embodied in case law—is primarily structural. The procedure commences with a discussion of how to delineate relevant markets. Market shares are then assigned and possible effects and the particular level of concentration are discussed. However, there is an obvious risk that the market definition ‘generally determines the result of the case’.3 In addition to the structural analysis, which concentrates on ownership and market shares, it is necessary to investigate the behavior and performance of the firms acting in the market. Typically, if one look at the performance the market needs to be modeled and some straightforward assumptions on behavior needs to be done. It is then possible to discuss outcomes of the mergers on prices, quantities, and the welfare for society. For example, the analysis could be focused on investigating whether the merger will change the characteristics of the market and the involved firms such that the likelihood of cartels, or tacit collusion increases.4

There are several obstacles that must be overcome by authorities investigating mergers or acquisitions. Most important is how to foresee the welfare effects of mergers. Welfare is in this case defined as the combined effect of a merger on industry profits and consumer surplus. No predetermined weight is used between the two components of welfare. If the authority could somehow make a relevant prediction, this could be the first step in a process where the firms, confronted with this prediction, could defend their case.

Traditional analytical tools such as econometric modeling are ill suited to the task of analyzing large discrete changes such as mergers. In addition, structural analysis makes no attempt to explicitly estimate the price or welfare effects of mergers. This form of analysis can only be compared with arbitrarily set threshold values. Values, which are neither explicitly based on economic models of oligopoly nor based on empirical studies of the effects of mergers or on studies of the relationship between market structure and economic performance, are poor indicators for the enforcement authorities to rely on when assessing a merger case.

In this paper, we investigate the welfare effects of an acquisition of one Brazilian mining company (CVRD) of mainly Brazilian based mining operations (CAEMI), approved by the European Commission in October 2001 (European Commission, 2001a). The primary production of the two companies is iron ore. To get the merger cleared by the Commission, the companies offered to sell off one of the merged entities, a mine in Canada. We investigate the welfare effects of this merger, using a simulation model. Simulation allows us to consider different scenarios, among them the scenario with no divestiture. Furthermore, by using different elasticities of demand for iron ore, the model's sensitivity to market delineation (definition) can be analyzed.

Section snippets

The iron ore industry

There are currently over 70 producers of iron ore in the world, none of which has reserves that are more than 15% of the known worldwide supply (Ericsson, 2004). The industry is present on all continents, although the more prominent producers are found in South America and in Australia. The Brazilian producers have, since the 1980s, increased their market share in Western Europe. The price trend for iron ore as a whole is decreasing. Hellmer (1997) claims that output for iron ore is relatively

The acquisition5,6

The merger, or more precisely the acquisition, that provides the case study for demonstrating the value of simulations is one between two Brazilian based companies, CVRD and Caemi. Caemi was partly owned by the large Japanese trading company Mitsui. The proposed acquisition combined the largest and the fourth largest global iron ore producers. The transaction met the thresholds for turnover within the European Economic Area (EU plus Iceland, Norway and Lichtenstein) and thus required approval

Merger simulation

The basic approach in merger simulation studies is straightforward. Pre-merger price and quantities are usually easy to observe, and it may be possible to find some empirical evidence on elasticities of demand for DRI. Using this information, a numerical model is calibrated so that its solution equals the observed prices and quantities. This is the pre-merger equilibrium. A proposed merger would, if permitted by the enforcement agencies, imply that firms reconsider their price- or

Model specification/calibration

Representing the pre-merger equilibrium involves making a choice of a particular set of market shares and prices to use in the model. This is needed for the calibration of the demand system. Theoretically, the correct sets are those that would have prevailed in the near future had the merger not taken place (Werden, 1997). However, this information is not available, thus, as used in the majority of cases, a proxy consisting of market shares and prices for some recent time period is used

Results and discussion

In the merger between Rio Tinto and North,10 the European Commission notes (in §18) that: “[…] a number of interested parties have submitted that fines, pellets and lump iron ore should be considered as three different product markets […] there is limited interchangeability between the different types of iron ore since the switching between them can significantly affect the efficiency of steel mills. […] It also appears that

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The views expressed herein are those of the authors and do no purport to be those of the Swedish Energy Agency.

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