THE European Union's recent recommendation to block the proposed $45 billion merger of General Electric and Honeywell International was based, in part, on an analysis by a noted French economist -- who has been dead for 124 years.
The economist is Antoine Augustin Cournot (1801-1877), the first scholar to apply mathematics to economics in a serious way. His book ''Researches Into the Mathematical Principles of the Theory of Wealth'' was published in 1838. Remarkably, it is still cited today for its astute analysis of competition and monopoly.
In one chapter, Cournot analyzed the strategic interactions between producers of complementary products, considering a market with two companies: a monopoly zinc producer and a monopoly copper producer. These two supplied a large number of other companies that combined the metals to produce brass. Cournot asked what would happen to the price of brass if the copper and zinc producers merged.
In the G.E.-Honeywell example, G.E. produces airplane engines and Honeywell produces navigation equipment, communications equipment, landing gear and a number of related products. Both sell their products to aircraft manufacturers like Boeing or Airbus. Like the copper and zinc producers, G.E. and Honeywell produce complementary products, and the European Union's merger task force naturally considered Cournot's 1838 analysis of ''mergers of complementors'' in preparing its report.
The standard economic analysis of mergers of complementors looks at two extreme cases: what happens if the industries are highly competitive, and what happens if the industries are highly concentrated?
If a company's complementary products are supplied in a highly competitive market, mergers with complementors are usually a bad idea from the viewpoint of profitability. Microsoft is happy to see a competitive market for PC components, since this intense competition pushes the price of PC's down, increasing sales for Microsoft. Microsoft clearly understands that selling a proprietary product that is complementary to a competitively supplied product is a great business to be in.
But what happens when there are a small number of providers of complementary products, as in the G.E.-Honeywell case? Only a handful of companies make airplane engines, and only a handful of customers buy them.
To examine what happens with only a few price-setting complementors, let us examine Cournot's case of the zinc and copper producers. If the copper producer cuts its price, brass producers will buy more zinc, thereby increasing the profits of the zinc producer. But the zinc producer's additional profits are irrelevant to the copper producer, making it reluctant to cut its price too much. The result is that the copper producer sets a price that is higher than the price that would maximize joint profits.
If, however, the copper and zinc producers merged, the merged entity would take into account that the price of copper affected the demand for zinc and set a lower price for both copper and zinc than independent producers would.
This is why a merger of complementors is normally considered a good thing: the combined company makes more profits than the premerger companies and prices are lower, making consumers better off.
So why did the European Commission recommend blocking the G.E.-Honeywell merger? They acknowledged that the ''Cournot effect'' would tend to lead to lower prices. But they then concluded that those low prices from the merged entity would make things a lot tougher for other producers of airplane equipment, like Rolls-Royce, Pratt & Whitney, Rockwell Collins and Thales. They may be right, but that is what competition is all about: make companies compete to push prices down and benefit the end consumers.
Furthermore, there is some question about how well the Cournot analysis applies in this case. Cournot looked at a model in which the copper and zinc producers each set a single price. In the airplane industry, Boeing and Airbus are not passive customers like Cournot's brass producers, but generally negotiate prices, and choose best-of-breed components rather than a prepackaged bundle. Indeed, the European Union's merger task force had a hard time coming up with examples of discounts for bundles in the avionics industry.
When evaluating a merger, United States antitrust officials tend to focus on the benefits to consumers, while European regulators give substantial weight to the impact on competitors, especially if they are ''national champions.''
These considerations strike American economists as perverse. Indeed, several notable antitrust experts, like Carl Shapiro of the University of California at Berkeley and Barry Nalebuff of Yale, testified at the recent hearing held by the European Commission that the G.E.-Honeywell merger was likely to be beneficial to consumers.
It is important that antitrust authorities and regulators understand the peculiar economics of complements since they are especially prevalent in high-technology industries, like avionics and computer equipment. Hardware is useless without software, operating systems are useless without applications, and distribution networks are useless without content to distribute.
It's tempting for companies to want to acquire complementary producers, for the reasons described above. But as we've seen, it isn't always a good idea from the viewpoint of profitability.
What could be more complementary than movies and VCR's, or music and CD players? Sony recognized this and acquired the Columbia and TriStar film studios in 1989 for $3.4 billion. Five years later it had to write off $3.2 billion in losses associated with these acquisitions. The lesson? Expertise in consumer electronics is of little use in the content industry; the basic production processes are just too different.
When companies' core competencies are very different, it usually makes more sense to work out other ways of coordinating pricing and interoperability standards.
Of course, antitrust authorities rightly frown on companies' coming together to set prices, since the effect is often anticompetitive. On the other hand, if the products are highly complementary and are produced in highly concentrated industries, producers left to their own devices may set prices too high because of the ''Cournot effect.'' Economic analysis offers significant insights, but there is still a judgment call about which models fit the facts best in a particular case.