This paper focuses on the proposed merger between America Online Inc. and Netscape Communications Corporation. It presents an overview of the two companies prior to the merger, identifies the issue/issues at hand, presents an in-depth analysis, and suggests alternatives using course concepts.

Overview

America Online Inc., based in Dulles, Virginia, is the world’s leader in branded interactive services and content. The company provides two worldwide Internet online services, America Online and CompuServe, with approximately 16 million members. Other branded Internet services operated by America Online Inc. include AOL.COM, Digital City Inc., AOL NetFind, ICQ, and others.

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Netscape was founded in April 1994, and currently employs more than 2000 people in 17 countries. The organization has been described as “the fastest growing software company in history.” Scores of individuals and companies large and small use Netscape software to host and manage Internet sites on the World Wide Web. More specifically, companies are now using Netscape for their intranets. The Netscape software line includes four families of products:

+ Netscape Communicator client software suite

+ Netscape SuiteSpot and FastTrack servers

+ Netscape Development Tools

+ Netscape Commerce Applications

At the present, Netscape Communications is a supplier of AOL Inc. Netscape is upstream from AOL; Netscape supplies its Internet browser (Netscape Navigator or

Netscape Communicator) to AOL. AOL is being charged a fee for the use of Netscape’s product. This fee is based both on a fixed and a variable component.

Netscape is currently undervalued as a company, but has valuable technology and resources that AOL can incorporate into its offering to its consumers. America Online’s proposed $4 billion acquisition of Netscape would offer a graceful and lucrative exit for an Internet pioneer that’s been foundering for a year. This will give AOL a chance to advance its position in the browser/content market. Furthermore, It would also fortify AOL’s arsenal against an increasingly aggressive foe: Microsoft.

Analysis and Recommendations

The main issue of concern is whether or not it is beneficial for AOL to keep on using the market as opposed to vertically integrating with Netscape. First of all, it may be argued that market firms can achieve economies of scale. As Netscape specializes in the production of its products, such as Netscape Navigator, it can achieve greater scale, and thus lower unit costs, than can the downstream firms that use the input. This is so because Netscape can aggregate the demands of many potential buyers, whereas a vertically integrated firm typically produces for its own needs. This assumption is based on the premise that a firm that builds its ability to self-manufacture for its internal needs would lack the necessary skills and be distracted in selling the excess product to outside firms.

In this case, AOL is acquiring Netscape rather than building its supply capability. Netscape has had experience and skills at selling to many buyers, and it will be producing its products for both internal and external use. Thus, in this case the merged company will also benefit from economies of scale. AOL will be able to use both Netscape and AOL products (for example, Netscape Navigator and ICQ) to promote its current and upcoming products, and thus enhance its customer base. Netscape’s Netcenter portal will also broaden AOL’s global audience at home and at work.

The proposed merger will advance AOL’s multiple-brand strategy with one of Internet’s best known brands; Netscape. This combination will increase the variety of products that AOL provides to the global market. These various products will allow AOL to benefit from economies of scope as the total cost of producing these products will definitely be lower when one company produces them than the two producing them individually.

The company may be able to lower costs by fully utilizing its resources (labour, materials, etc.) and fixed costs. Products requiring similar Research and development efforts and technology may also be less costly as such efforts are not duplicated. Thus, vertical integration will definitely lead to economies of scope due to the related nature of AOL and Netscape products. As a separate supplier, Netscape may also benefit from economies of scope and still be able to provide low cost services to AOL.

Similar to market firms, the merged company will also be subject to the discipline of the market. Since AOL will not be the only customer that Netscape deals with, Netscape has to produce efficiently and innovate to remain competitive in the marketplace, and not lose its business. Certain internal divisions that have a captive internal market are highly inefficient and fail to innovate. “The absence of market competition coupled with difficulties in measuring divisional performance, make it hard for top management to know just how well an internal division is doing relative to its best achievable performance”(ES, 1996). Such conditions often lead to high agency and influence costs.

A vertically integrated firm also avoids many of the coordination problems associated with a market firm. The new firm can achieve coordination within the company through centralized administrative control. As a market firm, Netscape may have had to provide AOL with timely access to browsers and any related information that was required. The nature of the input resulted in no design problems and thus, a low emphasis on the coordination of production flows.

By vertically integrating AOL benefits from not losing any valuable private information in the open market. AOL has special information about its products design or other consumer information that it values greatly, and would not want individuals in the market to know about. Dealing with Netscape as an independent supplier, AOL may risk losing confidential information through various sources (company employees, informal grapevines, etc).

If AOL uses the market to obtain its supply, it may have to incur transaction costs; costs that “arise when one or more parties to a transaction have a chance to act opportunistically”(ES, 1996). To prevent the other party from engaging in opportunistic behaviour, companies try to provide complete contracts. It is, however, quite difficult to specify complete contracts due to bounded rationality, difficulties in specifying or measuring performance, and asymmetric information. If it is assumed that Netscape is the only available provider of browsers to AOL, and that it (AOL) cannot develop its own browsers, then the holdup problem may arise.

This dependency of AOL may allow Netscape to raise its fee by claiming that its costs have risen. The seller may threaten to terminate the relationship if the buyer does not agree to renegotiate. The possibility of holdup increases the costs of transacting arm’s-length market exchanges. AOL may require more stringent requirements in their contract with frequent renegotiations. It may try to improve its expost bargaining position by looking for second sources of input (browsers), which are costly. Not only will there arise feelings of distrust between the parties, but also AOL may reduce its investment in relationship-specific investments.

Vertical integration will avoid this holdup problem and lower overall transaction costs. After the merger, the two firms will become one and are more likely to act cooperatively as they have a common mission and objectives. Moreover, rules, regulations, and authority relationships in the merged firm may prevent conflicts and any possibilities of holdup. If Netscape has monopolistic power in the market, it may be desirable that it vertically integrates with AOL. Merging can undo the harmful effects of double marginalization, where each firm independently equates its marginal revenue to marginal cost. Integration allows firms to achieve the level of production that maximizes profit in the vertical chain.

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