The deal is the agreed $85bn (£70bn) takeover of Time Warner (US:TWX), the HBO-to-CNN-to-Warner-Brothers production company, by AT&T (US:T), the biggest telecoms provider in the US. Its relevance to the work on contract theory by Messrs Hart, Holmström and others is that it addresses head on the basic question: when are companies better together and when are they better apart?
From the biased perspective of AT&T's boss, Randall Stephenson, there is no debate. Speaking with the spooky self-assurance of the archetypal US chief executive, the boss of the second-largest provider of mobile telecoms packages in the US tells a corporate video that "when it comes down to it, premium content always wins out. It has been true on the big screen and the TV screen and now it's proving true on the mobile screen. When you combine this content with (AT&T's) 100m-plus customers, you have something really special". Thus AT&T is offering a cash-and-shares deal to capture the maker of The Sopranos and - one for UK viewers - Waterloo Road. And Mr Stephenson concludes with the sound bite that "the future of video is mobile and the future of mobile is video".
Snappy stuff, Randall, but it may not work out like that and not just because AT&T plans to buy the company whose takeover by AOL in 2000 turned out to be "the biggest mistake in corporate history", according to the man who now wants to sell Time Warner to AT&T, its chief executive, Jeff Bewkes.
True, at the peak of the dot-com boom AOL paid more than twice the amount that AT&T is offering. Even so, some shortcomings of that deal may replicate themselves this time around. To see why, frame this proposed merger in generic terms relating to the media industry and ask this simple question: if vertical integration between service providers (eg, AT&T) and content suppliers (eg, Time Warner) is so wonderful then why isn't it the template? We can put that the other way around: the very fact that such mergers don't often happen - and, when they do, the results range from ordinary to lousy - is prima facie evidence that this type of vertical integration does not work.
Besides, why should there be such mergers? Contract theory tells us that an important reason why companies should merge is because it is intrinsically difficult for them to make mutually beneficial contracts; where, to use the jargon of the theory, there is a 'hold-up' problem. The classic example of the hold up is where a car-parts makes supplies dyes for a new car door to a car manufacturer. For the parts supplier, the problem is that the dye is worthless to any company except this particular carmaker and, at some stage, the carmaker will use that power to extract excess profits from the supplier. In turn, that discourages the car-parts supplier from making the necessary investment for new products. In those circumstances, said Bengt Holmström in a 1998 essay, "the best solution may be vertical integration".
Yet neither AT&T nor Time Warner are likely to face these threats. True, only Time Warner can supply AT&T with HBO's next blockbuster. Even so, making a contract to buy a TV series hardly qualifies as a hold-up matter. It's standard practice throughout the media industry and, even though AT&T will no longer have to haggle with Time Warner, it will still have to negotiate with the likes of Walt Disney (US:DIS) or even BBC Worldwide.
Similarly, Time Warner will still have to sell to other service providers even when it's in AT&T's stable. That said, changes to consumers' viewing habits - away from bundles of channels and towards pay-as-you-view - mean that Time Warner's bosses may be content with the comparative safety of having a big in-house customer. AT&T knew that, too - hence the parsimonious 20 per cent premium to Time Warner's pre-bid closing price in the offer.
So, to answer the question posed at the start, there is no obvious way in which these two companies are better together than they are apart. Even the confused way in which AT&T justifies the deal implies this. The company emphasises the $90m-worth of cost synergies to be squeezed out of the merger. Yet cost savings are usually the motive behind a horizontal deal, the merger of two companies that do the same thing. By contrast, this one is a vertical merger of two companies that occupy different stages of a commercial chain and therefore have different sets of costs. Granted, this factor makes it more likely the deal will get the regulatory go-ahead; the monstrous sums AT&T spends on lobbying should help, too.
Meanwhile, the bosses of BT (BT.A) may watch AT&T's move and conclude that it gives some legitimacy to their own ambitions for vertical expansion. It doesn't. A vertically integrated BT is a perfect example of the hold-up problem, the snag occurring at the point where it has to be compelled to give its service-providing rivals access to its monopoly infrastructure. The very fact that BT's network has to be regulated so comprehensively tells us it can't negotiate satisfactory contracts with other users of its cables. Of course that situation might be good for its shareholders, but it doesn't serve the interests of efficiency.
