The merger-paradox: A tournament-based solution

•We reconsider the merger paradox and propose an optimal merger mechanism.•Merged firms operate as independent subsidiaries.•Subsidiaries are rewarded based on a relative performance measure.•Mergers are never unprofitable and in many cases increase welfare.

According to the well-known “merger paradox”, in a Cournot market game mergers are generally unprofitable unless most firms merge. The present paper proposes an optimal merger mechanism. With this mechanism mergers are never unprofitable, more profitable than in other known mechanisms, and in many cases welfare increasing. The proposed mechanism assumes that merged firms continue to operate as independent subsidiaries that are rewarded according to a simple and commonly observed relative performance measure.