In October 1995, USAir (the United States' fifth-largest airline at the time) approached American Airlines first and then United Airlines about a possible buyout. American declined to bid, as did United. However, Ziemba (1995) reported that Robert Crandall, chair and CEO of American, indicated that American would have no alternative but to counterbid for USAir if United placed a bid. Thus, bidding and counterbidding were clearly possible, and an English auction (open oral, ascending) was being employed. Interestingly, because neither American nor United made a bid, USAir did not sell.
We show how this can happen even if the firm available for sale is worth more to the potential buyers than the available firm's reservation price. One key is what happens to a firm's profit if it loses the auction (i.e., two of its rivals merge). This work is related to the "auctions with externalities" literature, as in Jehiel and Moldovanu (1995, 1996) and Jehiel et al. (1996). Jehiel and Moldovanu (1996) focus on negative externalities exerted by the winning firm. In that case, in equilibrium, some firms may strategically commit not to bid in a sealed-bid auction. The object of the auction still sells, but firms that do not participate cannot avoid the negative externality. Our work adds the following insights. We analyze English auctions--unlike Jehiel and Moldovanu (1996)--and show that if losing the auction reduces a potential buyer's profit, then the available firm may actually fail to sell in equilibrium, whereas it would sell in a sealed-bid auction in which buyers cannot credibly commit not to participate. In the English auction, firms refrain from bidding if they realize that once the bidding starts, it will escalate into a profit-reducing bidding war. Intuitively, if bidding starts, firms bid offensively to get the gain from acquiring the available firm and defensively to avoid losing profit as a consequence of its rival obtaining the firm. Recall that Robert Crandall indicated that American would have no alternative but to counterbid for USAir if United placed a bid. The model in this article has the property described by Crandall. Second, we analyze cases where the "winning" firm confers positive profit externalities on the "losing" firm. In this case, the bidding starts (and the available firm sells) in an English auction because, even if a firm loses, its profit rises. Third, because of the prior insights, if an available firm fails to sell (and other conditions of the model are met), it might be considered evidence that a merger would reduce an outside firm's profit.
Finally, a novel aspect of how we model externalities in auctions highlights an important cause of bidding wars. Specifically, in our model the losing firm's profit not only changes because of losing but also increases with the price that the winner pays. The latter phenomenon may occur if paying a higher price puts more financial strain on the winner, thereby limiting its ability to make competitive improvements or strategic moves in the future. One may object to this because economic theory would say that once a competitor buys an asset, it immediately becomes (to some degree) a sunk cost and does not affect the output or strategic decisions of that firm. If capital markets are perfect, firms should be able to subsequently finance profitable strategic moves. (In such cases, the size of the winning bid should not typically affect the loser's long-run profit.) However, we have chosen to focus on cases for which a higher winning price limits the winner's future strategic moves and thereby negatively affects its profit (and positively affects the loser's profit). Perhaps capital markets are not perfect. Thus, the phenomenon of the size of the winning price affecting future strategic moves may arise more often than one might think. Airlines, for instance, are perpetually strapped for capital, and any increase in operations requires significant capital. …