When a big fish in the IT sector swallows a relative minnow, it can often seem that too much has been paid and too little gained by the buyer. But, given the major players didn’t become major players by making economically dumb decisions, are there some less obvious benefits to these transactions?

In their study, Professor Hui Kai Lung from HKUST Business School, and Professor Wang Qiu Hong from Singapore Management University’s School of Information Systems looked at when, how and for whom, these types of tech mergers and acquisitions (M&As) can be winners.

The IT industry has been rife with M&As, with many of these deals being acquisitions in which the established big players snap up innovative startups who are on their way to becoming giants themselves.

One notable example was the 2011 purchase of Skype by Microsoft, which was aiming to expand its presence in the instant messenger and voice over Internet protocol market. This element of its expansion plan, however, came with a hefty price tag of US$8.56 billion. What’s more, not only was Skype barely profitable at the time, Microsoft already had a strong presence in the instant messaging and video- and voice-chat markets.

So what is going on in this, and similar, high-stakes M&A deals in the IT industry? In addition to getting their hands on some cutting-edge technology, or simply increasing their market share, does the buyer obtain other strategic benefits from M&As? If so, what are these benefits, and is there also an upside for consumers?

The tech industry is different

First, let’s look at what’s unique about tech M&As. In this industry, an acquirer will inherit the acquired firm’s existing customers, and these customers may well want to stick with the products they know, at a price they’re used to. Also, consumers may not want an upgraded version of a product, or want it while it’s still the latest version available. Finally, tech products become obsolete after a certain period of time, for reasons such as a discontinuation of support services.

So even though a vendor can avoid competition by acquiring a rival firm, it will still face other challenges such as cannibalization and product obsolescence. Because of overlapping product generations, a vendor may sell old and new products to different consumers at different times, leading to opportunities for sophisticated pricing strategies. In this scenario, M&As may well bring new benefits that have not been well examined or explained in the past.

When a new competitor steps into the ring

Working within certain limitations, such as the use of a model based on a duopoly that operates in a closed market, the study looked at consumers’ purchasing history, to show how this affects demand when neither the IT vendors and consumers can anticipate which new products may be launched onto the market. The entry of Apple to the watch market, and Google to the global positioning system market, are examples of such unanticipated product launches.

Professor Hui and Professor Wang analyzed the strategic options open to a business that has acquired a new competitor, and evaluated the possible benefits of these strategies. They began by looking at a benchmark competition model in which an existing vendor selling a low-quality ‘old’ product, is joined in the marketplace by an entrant selling a high-quality ‘new’ product. The professors then compared the outcome with a scenario in which vendors get together through an M&A. As is customary with most analyses of IT products, it was assumed zero marginal costs were incurred.

The model used in this study also took on board an interesting phenomena: as the old product depreciates over time, the customers who’ve bought it may become more willing than new consumers to buy the new product.

Competition versus M&A

The professors found that new entrants to a competitive market will target consumers who place a higher valuation on quality (high-type consumers), despite the fact they already own the old product.

However, when an incumbent and an entrant compete with each other, three forces tend to suppress the new product’s price. First, given that low-type consumers will only buy the new product if its relative price is less than the value of the technological improvement, the incumbent can always charge a low price for the old product. Second, when selling to high-type consumers, the installed base of the old product cannibalizes the new product. Third, because tech consumers expect a price reduction in the future, this limits the price an entrant to the market can charge in the current period.

This analysis suggests that competition, cannibalization, and time inconsistency limit the profit that the entrant can earn from the new product. Without making a commitment on the future pricing of the product, it’s difficult to mitigate the latter effect, but the impact of competition and cannibalization can be reduced if the two vendors can get together and coordinate through an M&A.

For example, the professors found that one motivation of M&A could be simply to remove an old and competing product from the market. These M&As could also cause the new product to be variously introduced earlier or later (cf. under competition). What’s more, in markets where, initially, low-type consumers prefer the new product more than high-type consumers, but, also, where these groupings gradually reverse their preferences because of the depreciation of the old product, the acquiring business can adjust its pricing over time to extract the maximum possible profits from consumers.

What this means for tech businesses – and their customers

The study shows that when a tech product is subject to depreciation or economic obsolescence, and when there is an existing installed base, competition need not be good, nor consolidation bad, for consumers.

And when it comes to real-life product line design and pricing? The experiences of firms such as Apple and Microsoft seem fairly consistent with the strategic choices identified by Professor Hui and Professor Wang. Delayed new product introduction does seem common in some IT markets. For example, the technologies for fourth generation mobile telephone services have been available for some time, but to date, many service providers are still offering third or even second generation cellular services. What’s more, some software vendors such as Microsoft have been pushing back selling new versions of their software. It is entirely possible that their new products are not ready, but they could well be tackling cannibalization through the mechanisms the professors have pin-pointed in their research.