Luxottica, headquartered in Milan, Italy, is an eyewear manufacturer/wholesaler that has

been considering expanding vertically into the retail eyewear market. In 1995, Luxottica

acquired US Shoe, owner of the retail chain Lenscrafters. Luxottica presently controls 80%

of worldwide eyewear production, through brands such as Ray Ban, Prada, Chanel, Oakley

and Persol, and has been labeled a monopolist in the eyewear production industry.

"Sunglass Hut", a Florida-based retailer, was a major acquisition for Luxottica in 2001 and

represented a significant change of strategy, as Luxottica took a major stake in the retail

market by acquiring over 2000 stores (compared to the 300 they acquired in 1995), in a deal

worth around $400m. You are asked to examine the economics of this merger and for these

purposes, it's reasonable to treat "Sunglass Hut" as a firm with considerable market power in

the retail eyewear market.

Prior to the merger, Luxottica was the main supplier of eyeglass frames to Sunglass Hut.

Luxottica's marginal cost of producing a typical frame was $80. Luxottica charged a price W

per frame. This was Sunglass Hut's principal cost item; Sunglass Hut also had selling

expenses that worked out to about $20 per frame. The consumer's demand curve for

sunglasses is Q = 1,000,000 - 2,000*P, i.e., if the Sunglass Hut charges a price of $P for the

eyewear, then the above gives the number of units sold per year.

a. Suppose Luxottica decides to charge the Sunglass Hut a wholesale price of W=$200 per

frame. What price does the Sunglass Hut set?

b. Luxottica hires distinguished Kellogg students as consultants and decides to charge the

Sunglass Hut W=$280 per frame (this is the optimal price). What price does the Sunglass

Hut charge consumers? How many units are sold? What is the profit of the Sunglass Hut?

What is the profit of Luxottica?

c. Suppose Sunglass Hut is expected to make the above profit annually in perpetuity. On top

of these expected profits, Sunglass Hut owns $100m of other assets. Using a discount rate

of 10%, would you recommend to the shareholders of the Sunglass Hut to accept the

acquisition offer, which values the company at $400m?

d. Suppose the acquisition occurs and now Luxottica owns both the production and retail

side of the business. If the retail demand curve remains unchanged, and Luxottica's

marginal costs are $100 ($80 in production and $20 in retail), what price does Luxottica

want to set now? What are its profits? Was the deal worth it?

e. Given the profits of the two firms before the merger and Luxottica's profits after it, can

you quantify the externality that the independence of Sunglass Hut had on the eyewear

producers (i.e., the profit synergies which will be achieved after the merger)? Are

consumers better off before the merger, or after?