Threeway merger that is.  Or more accurately, how does a two firm merger depend on the possibility that one of the firms can merge with a third if their deal falls through?

This is the key issue in the potential United-Continental merger.  The deal has stalled because they cannot agree on the price.   Things were going well just after Continental learned that United was in merger talks with U.S. Airways.  Talks between United and U.S. Airways have collapsed because United started talking to Continental.  And as the United-U.S. Airways talks have collapsed, so have the Continental-United talks.

A man who has many girlfriends must find it hard to keep all their names straight.  I have a similar issue with this threeway merger post.  Back to the economics which I am also having a hard time keeping straight but here goes.

If two firms merge, the third firm standing outside gains:

The merged firms cut capacity and raise prices.  This is the main incentive to merge in the first place.  In the airline industry with its overcapacity and low profits,  consolidation and merger is a key strategy to regain profitability.  No wonder these firms flirt with each other periodically.  But if the merged firms consolidate, everyone else in the industry gains as prices go up.  The firms in merger talks do not take this positive externality into account in their flirtation.  They merge less than is ideal from the perspective of industry profitability. They date but don’t commit and the industry stays too large and unprofitable.

This analysis is consistent with the U.S. Airways strategy.  In a letter to employees, the C.E.O. says:

Whether we participate in a merger or not, consolidation will create a more efficient domestic industry that can better withstand economic volatility, global competition and the cyclical nature of our industry as a whole. As I have said many times, it is not necessary for us to be direct participants in a merger because the entire industry benefits when consolidation occurs.

But the same logic should apply to Continental: if the other two firms merge, Continental gains.  So, why did they go back to the negotiating table when they learned the other two firms were in merger talks?  There has to be some negative externality to Continental caused by a United-U.S. Airways merger.  Continental and United coördinate heavily even now – they are both in the Star Alliance, their flights link up etc. (I just flew to Newark on some joint Continental-United flight).  Antitrust authorities are going to take another look at the Continental-United relationship if the merger with U.S. Airways goes through.  A U.S. Airways merger can cause the Continental-United marriage to collapse.  So Continental has the incentive to work even harder at the marriage.

But of this was true before, it is still true now: if Continental and United can’t agree on a price, United can always go back to U.S. Airways.  This should lend some urgency to the merger talks.  To make a United-Continental merger more likely, the U.S. Airways C.E.O. should go back to talks with United.   The arrival of the ex-girlfriend can make the new girlfriend nervous and willing to commit.