Vertical and Horizontal Integration

Vertical integration, foreclosure, and productive efficiency
Author(s): Markus Reisinger and Emanuele Tarantino

Source: The RAND Journal of Economics, Vol. 46, No. 3 (Fall 2015), pp. 461-479
Published by: Wiley on behalf of RAND Corporation
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RAND Journal of Economics
Vol.46, No. 3, Fall 2015
pp. 461-479
Vertical integration, foreclosure,

and productive efficiency
Markus Reisinger*
and
Emanuele Tarantino**
We analyze the consequences of vertical integration by a monopoly producer dealing with two
retailers (downstream firms) of varying efficiency via secret two-part tariffs. When integrated
with the inefficient retailer, the monopoly producer does not foreclose the rival retailer due
to an output-shifting effect. This effect can induce the integrated firm to engage in below-cost
pricing at the wholesale level, thereby rendering integration procompetitive. Output shifting
arises with homogeneous and differentiated products. Moreover, we show that integration with
an inefficient retailer emerges in a model with uncertainty over retailers ' costs, and this merger
can be procompetitive in expectation.
1 . Introduction
■ How does vertical integration affect economic outcomes such as prices, quantities
consumer surplus? Is vertical integration solely about increasing market power, or can it en
productive efficiency and welfare? On the one hand, a large theoretical literature shows that w
a manufacturer deals with equally efficient retailers, vertical integration allows it to in
its market power by foreclosing rival retailers' access to the input it produces (see, e.g.,
and Tiróle, 2007). 1 On the other hand, the empirical literature presents evidence suggestin
* WHU - Otto Beisheim School of Management; markus.reisinger@whu.edu.

** University of Mannheim; tarantino@uni-mannheim.de.
We are indebted to the Editor (Benjamin Hermalin) for very insightful comments and suggestions. The arti
benefited from comments by three anonymous referees, Cédric Argenton, Heski Bar-Isaac, Felix Bierbrauer, Gia
Calzolari, Simon Cowan, Vincenzo Denicolò, Chiara Fumagalli, Massimo Motta, Volker Nocke, Marco Pagnozzi,
Peitz, Emmanuel Petrakis, Salvatore Piccolo, Patrick Rey, Armin Schmutzler, Nicolas Schutz, Marius Schwart
Shaffer, Kathryn Spier, Elu von-Thadden, Ali Yurukoglu, and Gijsbert Zwart. We also thank participants at the Un
of Bayreuth, University of Bologna, Pontificia Universidad Católica de Chile, University of St. Gallen, UCL (Louv
University of Oxford, CREST (Paris), University of Rochester (Simon), TI LEC - Tilburg University, ETH Z
seminars, and at the 2014 MaCCI Competition and Regulation Day (Mannheim), 2014 Industrial Organization Work
(Alberobello), and 2012 Annual Searle Center Conference on Antitrust Economics and Competition Policy (Northw
University).
1 There is also evidence that integration leads to foreclosure of competitors (Chipty, 2001; Hastings and Gilbert,
2005; among others).
Copyright ©2015, RAND. 461
462 / THE RAND JOURNAL OF ECONOMICS
efficiency-based mechanisms are behind vertical integration (e.g., Hortaçsu and Syverson, 2
Several studies show that the efficiency gains produced by vertical integration can outwei
welfare losses caused by foreclosure: in their survey of empirical research, Lafontaine a
Slade (2007) conclude that, in most circumstances, profit-maximizing vertical integration
consumer welfare.
This article analyzes the welfare consequences of vertical integration using a model in which
a dominant producer sells through retailers that have different marginal costs of production. We
find that vertical integration with the less efficient retailer can raise consumer surplus and total
welfare by improving productive efficiency. The mechanism we put forward features the integrated
firm's upstream unit selling its input on favorable terms to the unintegrated efficient retailer, to
induce this retailer to expand its output. This output-shifting effect gives rise to a procompetitive
outcome whenever the integrated firm engages in below-cost pricing at the wholesale level.
In our model, a monopoly producer sells an intermediate good via secret two-part tariffs
to competing retailers. In contrast to the standard setting employed in the literature, we allow
retailers to have different marginal costs of production.
Without integration, a monopoly producer's limited commitment with unobservable con-
tracts prevents it from monopolizing the final-product market (e.g., Hart and Tiróle, 1990; O'Brien
and Shaffer, 1992; McAfee and Schwartz, 1994; Rey and Tiróle, 2007; White, 2007): see our
Lemma 1 . Consistent with earlier findings, integration with the more efficient retailer yields the
monopolist full market power because it can foreclose the inefficient (and competing) retailer:
see Proposition 1. If, instead, the monopolist were integrated with the less efficient retailer,
would the integrated firm still pursue a foreclosure strategy? We show that the answer can be
"more than no": the newly integrated firm may reduce the unit price to the unintegrated, but
more efficient, retailer even below the marginal cost of production.
The upstream firm faces the following trade-off. A reduction in the unit price to the unin-
tegrated retailer raises industry quantity and thus reduces industry revenue. However, a counter-
vailing effect arises in our framework: the reduction in the unit price to the unintegrated retailer
is known by the integrated firm's downstream unit, which responds by reducing its quantity. A
lower unit price then triggers an increase in the unintegrated and more efficient retailer's quan-
tity and profit. The integrated firm can extract this higher profit via the fixed component of the
two-part tariff. We show that the reduction in industry revenue is outweighed by the fact that the
industry produces more efficiently. Indeed, we find that the unintegrated retailer will be active in
the final-good market as long as it is strictly more efficient than the integrated downstream unit:
see Proposition 2. This establishes the output-shifting effect of vertical integration.
A question of importance for competition policy is the magnitude of the output-shifting
effect. Specifically, can the incentive to reduce the unit price to the unintegrated firm be so strong
as to render vertical integration procompetitive with respect to an unintegrated industry? We show
in Proposition 3 that the output-shifting effect can induce the upstream unit of the integrated firm
to engage in below-cost pricing at the wholesale level. This leads to an expansion of industry
output relative to vertical separation and renders vertical integration procompetitive. We find that
below-cost pricing is more likely to occur when cost differences between retailers are particularly
large.
The integrated upstream producer's problem can be seen as a particular Stackelberg game,
in which the upstream firm moves first and the integrated retailer follows. In the first stage,
the upstream monopolist sets the input price to the unintegrated retailer, thereby determining
this retailer's output. Because the upstream firm can extract the competing retailer's profit via
its two-part tariff, it effectively chooses the rival's output to maximize industry profit, under the
constraint that its inefficient downstream subsidiary seeks to maximize its own profits. If retailers'
2 Specifically, the property-rights theories (e.g., Grossman and Hart, 1986), the theories highlighting the role of
transaction costs (Williamson, 1971, among others), and those looking at the elimination of double marginalization (e.g.,
Salinger, 1988) show that vertical integration can raise efficiency.
©RAND 2015.
REISINGER AND TARANTINO / 463
cost differences are large enough, the profitability of output shifting is particularly large, indu
the upstream firm to set a unit price below marginal cost. By this strategy, the integrated f
commits to a reduction of its downstream firm's output.
In the main model, we assume that retailers offer a homogeneous good. We show that
our results are robust to retailers offering differentiated products. We again find that when
monopoly producer is integrated with the inefficient retailer, it engages in output shifting, whi
can result in a procompetitive outcome.
The discussion thus far begs the question of why would the upstream monopolist mer
with the inefficient retailer. This might happen because the antitrust authority forbids a me
with the efficient retailer because it leads to market monopolization (as shown in Propositio
In this respect, the model provides a motivation why the upstream monopolist can only mer
with the less efficient retailer. There are also several alternative explanations. For example,
efficient retailer might be part of a large conglomerate, which prevents the upstream monop
from acquiring it. Also, due to historical reasons the upstream firm might be integrated wi
retailer when the industry is liberalized, and a more efficient retailer enters the market. In addit
we demonstrate that a market structure in which the monopoly producer is integrated with
inefficient retailer can arise in a model where the upstream monopolist's integration decis
is taken under uncertainty over retailers' marginal cost of production. Specifically, we prov
the conditions such that the monopoly producer merges with a retailer that is less efficient
expectation and this merger leads to a procompetitive outcome (Proposition 4).
The "Chicago School" has challenged the view that an upstream monopolist needs
integrate to monopolize a competitive downstream market (e.g., Bork, 1978; Posner, 1
among others). It has also disputed that an integrated monopoly producer has an incentive
exclude competing firms that can be the source of extra rents thanks to, say, cost efficiency.
post-Chicago School literature has noted that, when wholesale contracts are secret, the upstr
monopolist's market power is eroded by a commitment problem that prevents it from monopoliz
the final-good market.3 In this literature, vertical integration allows a dominant supplier to rest
its market power by foreclosing the competing retailer's access to the intermediate good. We
on the post-Chicago School literature by embracing its approach. At the same time, we borr
from the Chicago School the idea that the dominant producer might deal with retailers w
different marginal costs of production. We show that in line with the Chicago School argume
these differences in marginal costs give rise to an output-shifting effect that can render ver
integration procompetitive with respect to separation.4
This result suggests that, for example, policies of divestiture imposed by regulatory agen
to prevent foreclosure can have unintended consequences and may well be misguided. Rey
Tiróle (2007) list some of the major decisions of divestitures taken by antitrust authoritie
from the 1984 breakup of AT&T to the separation of electricity generation systems from h
voltage electricity transmission systems in most countries. Consistent with our conclusion
Lafontaine and Slade (2007) document that studies assessing the implications of these force
vertical separations generally find that such legal decisions lead to price increases.
Other articles have analyzed vertical integration in different, but related, contexts. For e
ample, Ordover, Saloner, and Salop (1990) and Chen (2001) consider the case of public offer
in linear prices. Choi and Yi (2000) develop a model in which upstream firms can choose to
customize their inputs to fit the needs of downstream firms, and Riordan (1998) consider
model in which a dominant firm has market power in the final- and intermediate-good mar
Finally, Nocke and White (2007) analyze the effects of vertical integration on the sustainabil
3 This commitment problem was first noticed by Hart and Tiróle (1990), and then further analyzed by O'Brie
and Shaffer (1992), McAfee and Schwartz (1994), Rey and Vergé (2004), Marx and Shaffer (2004), and Nocke and
(2014).
4 Asymmetry in retailers' marginal costs can arise endogenously in a setup with providers of complementary inputs
(as in, among others, Laussel, 2008; Laussel and Van Long, 2012; Matsushima and Mizuno, 2012; Hermalin and Katz,
2013; Reisinger and Tarantino, 2013).
©RAND 2015.
of upstream collusion. These articles find that integrated firms have an incentive to foreclose the
downstream rivals. Instead, we show that an integrated firm wants to keep a more efficient ri
retailer alive, and serve it on favorable conditions when particularly efficient.
Our article is also related to the literature on vertical relationships that emphasizes the ro
of differences among retailers. Inderst and Shaffer (2009) and Inderst and Valletti (2009) stud
the implications of price discrimination in input markets when buyers are asymmetric.5 Relatedly
Chen and Schwartz (2015) analyze the welfare effects of monopoly price discrimination wh
costs of service differ across consumer groups. Finally, Spiegel and Yehezkel (2003) analyze th
case in which retailers are vertically differentiated. However, this literature does not study vertic
integration, and therefore does not examine the forces at work in our model.6
The article is structured as follows. Section 2 presents the model, and Section 3 provide
the equilibrium analysis. Section 4 shows the robustness of our main results when retailers off
differentiated products. Section 5 presents a model with equilibrium vertical integration whe
retail costs are uncertain. Section 6 concludes. Proofs can be found in the Appendix.
2. The model
■ An upstream firm, U , is a monopoly producer of an intermediate good

production cost c. It supplies two retailers, Dx and D2, that are Cournot rivals in
market. The retailers transform the intermediate good into a homogeneous final pro
to-one basis. In contrast to the previous literature, we allow retailers to have diff
costs of production. Specifically, retailer ZVs constant marginal cost of producti
retailer Z)2's marginal cost is /¿2, with ß2 > l¿' • We assume that the difference betw
is small enough that both retailers are active when they obtain the intermediate g
cost c.
Each retailer produces a quantity of q¡ , i = 1,2, resulting in an aggregate retail output

of Q = qx + q2. The (inverse) demand function for the final good is p = P{Q). It is stric
decreasing and thrice continuously differentiable whenever P(Q) > 0. Moreover, we employ
the standard assumption that P'Q) -h QP '(Q ) < 0, which guarantees that the profit functio
are (strictly) quasi-concave and that the Cournot game exhibits strategic substitutability (Viv
1999). We also assume that P"'(Q ) is not too negative. This ensures concavity of the monop
producer's profit function.
When contracting with retailer Z), , / = 1, 2, the upstream monopolist makes a take-it-o
leave-it offer of a two-part tariff contract consisting of a fixed component, Fi9 and a unit pr
Wj.7 If it accepts, retailer Ą's total marginal cost is /z, + w¡.
We consider two scenarios: firms are not integrated (vertical separation) or the monopol
producer U is integrated with one of the two retailers (vertical integration). Given vertica
separation, the game proceeds as follows:
(i) U secretly offers to each retailer D¡ a two-part tariff [w¡, F¡} = T¡.
(ii) Retailers simultaneously accept or reject the contract offer.
(iii) Retailers order a quantity of the intermediate good, q¡ , and pay the tariff. Then, they transfo
the intermediate good into the final good and bring output to the market.
Afterward, retail purchases are made, and profits are realized.
5 Hansen and Motta (2012) consider a model in which retailers differ in their production costs due to cost shock
but neither the manufacturer nor rival retailers observe the cost realization. They show that if retailers are sufficiently r
averse, the manufacturer optimally sells through a single retailer.
6 An exception is Linnemer (2003), who studies the implications of vertical integration on welfare in a model w
asymmetric retailers. However, he restricts his attention to the analysis of the impact of foreclosure on market structure
7 In the web Appendix, we show that letting the upstream monopoly use quantity-forcing contracts instead o
two-part tariffs yields the same equilibrium allocation.
©RAND 2015.
We solve for the perfect Bayesian Nash equilibrium that satisfies the standard "passi
liefs" refinement (Hart and Tiróle, 1990; O'Brien and Shaffer, 1992; McAfee and Schwart
Rey and Tiróle, 2007; Arya and Mittendorf, 201 1). With passive beliefs, a retailer's con
about the contract offered to the rival is not influenced by an out-of-equilibrium contrac
it receives. This is a natural restriction on the potential equilibria of a game with secret
and supply to order because, from the perspective of the upstream monopolist, under th
assumptions retailers D{ and D2 form two separate markets (Rey and Tiróle, 2007).8
In the scenario with vertical integration, the monopoly producer U and its downst
affiliate maximize joint profits. The game proceeds as laid out above, with the exception
is natural and in line with Hart and Tiróle (1990) and Rey and Tiróle (2007), the downst
affiliate of the integrated firm knows the terms of č/'s offer to the rival retailer. We also assum
the downstream affiliate knows the acceptance decision of its rival. However, the outcom
be identical if the downstream affiliate was not informed about this decision. This is because the
integrated retailer correctly anticipates the equilibrium action of the rival (which is to accept Č/' s
offer).
We denote by q™ the monopoly quantity produced by retailer D¡ when it alone obtains the
intermediate good at marginal cost ( w¡ = c),
q™ = arg max ( P(q ) -c- /i^q,

q
whereas n™ denotes retailer D¡ 's monopoly profit when producing q !" :
7 t!" = max ( P(q ) - c - ßi)q.

q
The Cournot equilibrium is the solution to the system
q i = arg max (P(q + q2 ) - w] - ß{)q and q2 = arg max (P(q] + q) - w2 - fi2)q.

<i <i
Let q
of in
< = (p (tí + tí-) ~c~ Pi) tí 0)

denote D¡ 's equilibrium profit when U sets the unit price uniformly a
3. Equilibrium analysis
□ Vertical separation. Suppose neither retailer is vertically integrated. Because retailer Dx
is (weakly) more efficient than Z)2, U would ideally like to monopolize the product market by
inducing Dx to sell the monopoly output (#"'). It might seem it can achieve this outcome by
making an unacceptable offer to D2 and offering T(" = {c, 7r¡"} to Dx. However, Dx understands
that, because offers are secret, U' s offer to D2 is not credible. The reason is that U has an incentive
to sell an additional amount to D2.9 So Dx would incur a loss if it accepts. Retailer Dx will thus
turn T{" down.
Lemma 1. With passive beliefs, the upstream monopoly (U) offers, in equilibrium, each retailer
a two-part tariff with the unit price equal to č/'s marginal cost and the fixed component equal to
the retailer's resulting profit in the ensuing Cournot competition; that is, the equilibrium tariff
offered to retailer D¡ is T¡ = { c , n.}.
8 All our results hold true under the alternative assumption that retailers hold wary beliefs (McAfee and Schwartz,
1994; Rey and Vergé, 2004).
9 This result follows from the observation that given = q"' q2 = argmax^ (P(q + q™) - c - ¡x2)q > 0. Given
r,w, when secretly renegotiating with D2, the upstream monopolist maximizes the value of the contractual relationship
with this retailer, and the profits that U can extract from D2 are positive.
©RAND 2015.
This result is well known. Intuitively, a retailer's decisions cannot change if U deviates
offer to the rival retailer. Therefore, when the monopoly producer contracts with each retail
acts as if the two are integrated. This pairwise maximization problem requires that the contra
arrangements between U and D¡ maximize bilateral profits. This entails a unit price equal
monopoly producer's marginal cost (c). Consequently, each retailer produces its Cournot qu
and the upstream monopolist reaps the sum of Cournot profits iz' + 7t2c via the fixed comp
of the two-part tariff.
□ Vertical integration. With vertical separation, the equilibrium has retailer Dx produc
q' and D2 producing ql2 . From U' s perspective, a better profile is q' + 1 and qc2 - 1. In
revenues are the same, but costs have fallen, because Dx is more efficient than D2 and, vi
fixed component, U can capture this increase in surplus. Integration is a way for U to imp
a more profitable production profile. We consider two cases: U is integrated with the eff
retailer (£>,), or it is integrated with the inefficient retailer (D2).
Vertical integration between U and Dx. As shown by Hart and Tiróle (1990) and Re
Tiróle (2007), U internalizes the effect selling to the rival retailer has on the profits made
own affiliate. Therefore, the temptation of opportunism vanishes and U can credibly com
reducing supplies to the rival retailer. This is the foreclosure effect of vertical integration.
Proposition 1. Suppose the upstream monopolist U is integrated with retailer Dx . In equilib

the integrated firm U-Dx forecloses retailer Z)2's access to the intermediate good. Hence, r
D j produces the monopoly output (qx = gj"), retailer D2 is inactive (q2 = 0), and U-Dx ob
the monopoly profit 7r[".10
For U, integration with retailer Dx is more profitable than remaining separate, becau
allows the integrated firm to monopolize the market for the final good.
Vertical integration between U and D2 (the inefficient retailer). We solve for U 's optima
to its downstream unit D2 and the competing retailer D', leading us to Proposition 2.
Proposition 2. Suppose the upstream monopolist, U, is integrated with the inefficient reta
The unique equilibrium has firm U-D2 trading the intermediate good internally at margin
(w* = c) and setting a unit price w' such that the efficient unintegrated retailer Dx is act
the market for the final good (q'(w', c ) > 0) if and only if Dx is strictly more efficient th
that is, iff /¿i < ļi2.
As will be seen, the integrated firm is better off shuttering its inefficient downstream u
However, in our setting, U cannot do so credibly.11 Critically, Proposition 2 shows that th
grated firm U -D2 does not necessarily foreclose the competing retailer's access to the interm
good. To grasp the incentives of U -D2 when setting wu consider the trade-offs it faces. By r
the unit price to the competing retailer Du U forecloses ZV s access to the intermediate
and monopolizes the market for the final good (the foreclosure effect). However, a counter
effect exists in our framework. U benefits if the quantity produced by the efficient reta
increases, at the expense of D2. How can the upstream firm achieve this, given that it cannot
mit to restricting its downstream affiliate's quantity? As, with vertical integration, D2 ob
U9s offer to Du U needs to lower the unit price wx ' in this way, ZVs quantity increases
responds by reducing its output. U then extracts the profit of Dx via the fixed component
two-part tariff. This establishes the output-shifting effect of vertical integration.
10 The proof of Proposition 1 follows the same lines as in Hart and Tiróle (1990), and is therefore omitted.
1 1 We discuss in the conclusions the motives that lead U not to shut down D2 in models that dispense wit
commitment assumption.
©RAND 2015.
The integrated upstream producer's problem can be seen as a choice between a mar
structure featuring a monopoly and one featuring a particular Stackelberg game. When
monopoly, ř/'s choice is constrained insofar as it can make only its own affiliate the dow
monopolist. When choosing Stackelberg, U acts as a leader by setting w j, thereby determ
Dx 's output. The downstream affiliate acts as the follower with marginal cost fi2 + c.
U can capture all of the downstream profits via its two-part tariff, unlike a standard Sta
game, the Stackelberg leader chooses D{ 's output to maximize industry profit, under the con
that its inefficient downstream affiliate (the follower) seeks to maximize its own profits.
In equilibrium, Dx is foreclosed if and only if the two retailers are equally efficient (¡ix
Then, D2 produces the monopoly quantity q™. At q the marginal revenue of output is
to the marginal cost of D2' thus, a small reduction in D2 s output has no effect on the p
U-D2. If ¡i' < fi2 , it is profitable for U-D2 to expand ZVs output even though this inc
industry output and therefore reduces industry revenue.12 The reason is that at q ™ the m
revenue of output exceeds Dx 's marginal cost of production. The increase in industry output
the monopoly level yields a second-order loss, but there is a first-order gain from hav
additional output unit produced more efficiently.
Finally, a revealed preference argument shows that for U , a vertical merger with retail
is more profitable than no integration at all. As the Stackelberg structure encompasses C
competition with a common unit price of c, which is the outcome with vertical separati
monopoly by D2, it must be weakly more profitable than either. That it is strictly more
Cournot follows because industry profit rises in a Cournot equilibrium if one firm redu
output or if output is produced more efficiently. That it is strictly superior to monopoly
follows from the first-order gain due to the production expansion by the more efficient ret
A question of importance for competition policy regards the magnitude of the output-sh
effect. Specifically, can the incentive to reduce w j be so strong that U offers a unit price b
marginal cost of production (i.e., if* < c)? This would render vertical integration procom
because wholesale prices would be lower for one retailer and no greater for the other com
vertical separation, leading to larger industry output and consumer surplus. Proposition
that this can indeed occur.
Proposition 3. The integrated firm U-D2 sets a unit price w' below its marginal cost of production
c, thus rendering vertical integration procompetitive, as long as the difference between ¡x2 and /xl
is sufficiently large.
Proposition 3 indicates that below-cost pricing is more likely to occur, the more efficient Dx
is relative to D2 (i.e., if /x2 - /Xi is large). The more efficient Du the higher the profit increase
that the integrated firm obtains when shifting output to D' . Therefore, reducing the per-unit price
is particularly valuable to the upstream monopolist.13
The output-shifting effect can be linked to the rate of cost pass-through. A cost increase is
shifted to consumers at a rate that depends on the curvature of consumer demand (Bulow and
Pfleiderer, 1983; Weyl and Fabinger, 2013). Specifically, the pass-through rate is larger if the
demand function is relatively convex. As a result, below-cost pricing is more likely to occur when
the demand function is concave, because the unintegrated retailer D{ then adjusts its quantity
only slightly in reaction to a change in W'. Thus, U must reduce its unit price by a large amount
to induce Dx to expand its quantity.
To illustrate these results, suppose P(Q) = a. - ßQ, with ß > 0 and a > c + ¡jl2. Denote
by A the difference between retailers' marginal costs of production, /x2 - Mi- With vertical
12 Indeed, a reduction in triggers an increase in qx that is larger than the consequent decrease in q2, implying
that aggregate output rises.
13 The conditions leading to procompetitive vertical integration are the same in a model in which U competes with
a fringe of less efficient upstream firms. The proof is in the web Appendix.
©RAND 2015.
FIGURE 1
LINEAR DEMAND EXAMPLE
separation, if Dx and D2 receive the input at marginal cost c, both are active on the fi
market provided A is smaller than A = (a - c - fi')/2. If U is integrated with the less e
retailer D2, it sets a unit price w' equal to (a + c + 4/¿i - 5/x2)/2if A < A = (a - c - /Xi
2¡jl2 - Mi + 2c - a if A > A, where A is the threshold such that D2 is inactive when rec
the input at w2 = c, given that Dx receives the input at w' - w*. In line with Propositi
we find that vertical integration between U and D2 is procompetitive (w* < c ) if
if A > Ac = (a - c - ¡jL')/59 whereas it is anticompetitive for values of A below A
Ac < A.14 The left panel of Figure 1 plots these conditions using a = ß = 1 and
The shaded area shows when vertical integration between U and D2 is procompetitive,
equilibrium value of Wi lies below the upstream monopolist's marginal cost c.
The right panel of Figure 1 plots the value of w' as function of A using a = ß = 1,
and /¿ļ = .15. If retailers are equally efficient, U sets a unit price such that the uninte
retailer's access to the downstream market is foreclosed. As A increases, U reduces the u
to induce its downstream affiliate ( D2 ) to reduce its output at the advantage of the more ef
and unintegrated retailer ( Dx ). Once A becomes so large that, given D2 remains inact
if A > A), U can raise wx to limit the distortion of industry output. This shows that w'
nonmonotonically in the difference between the costs of D2 and Dx.
4. Differentiated products
■ The main model considers competition between retailers offering a homogeneo
good. In this section, we analyze the case in which Dx and D2 offer differentiated pro
We assume that retailer Ą's inverse demand function is equal to P¿ {qi , #_,) = a - ßq>
with /,7 = 1,2 and i ^ y', where the parameter y e [0, ß) reflects the degree of substit
between ZVs and D2 s products. Because ß > y > 0, inverting the system of inverse dem
functions yields the direct demand functions we will use in the analysis with price com
We further impose that a > c + fi2.
We will analyze whether, due to the output-shifting effect, vertical integration b
the upstream monopolist ( U ) and the inefficient retailer (D2) results in an outcome t
14 Note that for all A > 0, the profits of U-D2, when the unit price is equal to w*, are strictly larger than the
of the integrated firm when foreclosing D} 's access to the intermediate good.
©RAND 2015.
FIGURE 2
procompetitive relative to the one with vertical separation. Before proceeding, note that if ret
offer differentiated products, vertical integration may not lead to full monopolization of the
good market even in a setting with equally efficient retailers. Indeed, the integrated firm
generally maintain the rival retailer active, although in a discriminatory way.
Retail quantity competition. Let us first consider the case of quantity competition betwee
and D2. In line with Lemma 1, when no firm is integrated, the intermediate good is suppl
the upstream monopolist at a unit price of w¡ = c, so that retailers produce respective C
outputs. When U is merged with retailer D2, we proceed in the same way as in Proposition
find that the integrated firm sets a unit price equal to
c _ (4ß2 + y2)y(tt -c-ļJL i - A) + 8 ß3c - 2ßy2(2a + c - 2 ļix)

W> ~ _ ījiījījP^īp) '
which decreases in A for all ß > y > O.15 This shows
shifting. That is, for all positive values of A, the integ
D' than in a setting with equally efficient retailers.
Can output shifting result in a unit price below
Figure 2, we illustrate that w f lies below c for all v
the threshold below which both firms are active whe
cost. Thus, the shaded area is the one in which vert
procompetitive outcome with respect to vertical sepa
Retail price competition . We now analyze whether

when retailers are Bertrand competitors that offer d
case of quantity competition, where retailers order q
on the final-good market, with price competition e
and then orders the quantity q¿ of the intermediate
2004). We therefore follow the literature and modify
15 The value of wf when the integrated unit is inactive is equ

consistent with the results for the case of homogeneous goods (F
in A.
16 For the figure, we use the following parameter values: a =

we also assume that ¡i{ = .15.
©RAND 2015.
letting retailers first simultaneously choose final good prices and then order the quantity to
their demand, transform the intermediate good into the final good, and pay the tariffs.
This change in the timing of the game implies that with downstream Bertrand compet
the assumption of passive beliefs is not as reasonable as with Cournot competition (Rey and
2004; Rey and Tiróle, 2007). The reason is that contracts are interdependent from the pers
of the upstream monopoly: retailers pay their tariffs to U only after their demand is re
thus, a change in the unit price to retailer D¿ affects the payment that U receives from r
D-i, thereby invalidating the approach with passive beliefs. In addition, if products are
substitutes, an equilibrium fails to exist with passive beliefs. We therefore focus on wary b
which circumvent these problems. Rey and Vergé (2004) solve for the equilibrium of a gam
Bertrand competition and wary beliefs. They find that, in a vertically separated industry, the
price offered by the upstream monopolist lies above marginal cost (c).17 Although the equil
cannot be solved for analytically, this can be done numerically. For example, for a = ß =
y = 0.7, c = 0.2, and ßx = /x2 = 0.1, we obtain unit prices given by wx = w2 = 0.31 1.
Let then U be integrated with D2. As the problem of conjectures does not arise with ve
integration, we obtain an explicit solution. Proceeding as in Proposition 2, 18 we find tha
sets a unit price wx equal to
B _ {Aß2 + y2)y{ a - c - ßx - A) + 8 ß3c + 2ßy2(2a + 3 c - 2¡ix)

W 1 _ ~ 2ß(4ß2 + 5y2) '
Clearly, decreases in A for all ß > y > O.19
This shows that U-D2 sets a lower unit price to Dx than
¡xx coincide, thereby inducing retailer Dx to expand its output
downstream unit. Moreover, it can be shown that wf > c for
engages in below-cost pricing. For instance, using values of the
wf = 0.477 (and w2 = 0.2 due to internal transfer pricing at m
Although the wholesale price to Dx is never below marginal
D2 can still be procompetitive. This is because, with wary belief
w2 are larger than c. To show that vertical integration can incre
to vertical separation, we use numerical computations. We find
constellations for which vertical integration is anticompetitive w
but procompetitive when Dx is more efficient than D2. For ex
values as above, in which retailers are equally efficient, verti
consumer surplus, whereas it increases consumer surplus if ļi
is again that, as retailer Dx becomes more efficient, C/'s unit pric
falls relative to the one with vertical separation. This result is i
main model: productive efficiency increases and this makes ver
5. Vertical merger under uncertainty

■ In this section, we study the monopoly producer's integrat
retailers' marginal costs of production are uncertain, reflecting
is a long-term decision. We show that a market structure in
integrated with an inefficient retailer might arise in equilibrium
procompetitive in expectation.
17 Instead, with passive beliefs, if an equilibrium exists, it leads to a unit pr

18 Rey and Tiróle (2007) show that the analysis with integration follows the
downstream, with the exception that retailer D2 takes into account that a cha
quantity of retailer Dx , and thus the payment that its upstream affiliate receives
19 The value of wf when the integrated unit is inactive is [ß(2ß2 - y2)
<t3]/[k(0 + y)(ß - /)]•
©RAND 2015.
REISINGER AND TARANTINO / 47 1
□ Setup with uncertainty. As in our base model in Section 2, the monopoly produce
deals with two retailers, Dk and Ds. The marginal cost of retailer Dk is known and equal to f
Conversely, the marginal cost of retailer Ds is stochastic. Specifically, it can take on two va
ß + k with probability p , and ¡i - k with probability 1 - p, with k > 0. Thus, the expected
value of Dy's marginal cost is p(ļi + k) + (1 - p){¡i - k). For reasons that will become c
later on, we restrict attention to p e [1/2, 1). If p = 1 /2, then Dk and Ds are equally efficien
expectation. Instead, Dk is more efficient in expectation than Ds for all values of p larger th
1/2.
The game develops in two stages:
I. The monopoly producer U decides whether to merge with retailer Dk or Ds.

I'. Uncertainty over retailer A's marginal cost realizes.
II. The game of Section 2 takes place.
We solve the game by backward induction. In stage //, absent integration, the results in
Lemma 1 regarding U 's pricing decisions apply. Instead, if U is integrated, the results in Proposi-
tions 1,2, and 3 apply. Finally, the merger decision takes place in stage /, before uncertainty over
A 's marginal cost realizes in the intermediate stage rě
In what follows, we assume that the consumer demand function is linear and equal to P(Q) =
a - ß Q, with ß > 0 and a > c + ¡i + k. Moreover, we assume that k < k = (a - c - /x)/2, the
threshold below which both retailers are active when receiving the input at marginal cost.
□ Merger decision. First note that regardless of whether U is merged with the more efficient
retailer, vertical integration is profitable. This follows directly from the results in Section 3 and
simplifies the rest of the analysis, because it implies that we can focus on the monopoly producer's
merger decision. Will U merge with the retailer whose marginal cost of production is certain (A)
or with the one whose marginal cost is stochastic ( A )? To answer this question, we first consider
the case in which the two retailers are equally efficient in expectation (p = 1 /2).
Lemma 2. If p = 1 /2, the monopoly producer integrates with the retailer whose marginal cost
of production is stochastic ( A ).
One might expect that, given that U captures the industry profit with two-part tariffs, it is
irrelevant which retailer it owns. However, there are two reasons why expected profits differ. The
first is due to the fact that profits are convex in costs. Let us denote by tc m(C) the monopoly profit
of a retailer when facing marginal cost of C.20 If the unit prices set by U under integration were
at the foreclosure level, the difference in expected profits between merging with A and Dk is
^[j īm(ļl - k + C) + 7Tm(ļl + k + c)] - nm(ļi + c),

which is positive by the convexity of profits in costs. This observation alone is not enough to
explain the result in the lemma, because setting the unit price at the foreclosure level is not optimal
if U happens to be integrated with the less efficient firm.
The second reason is related to the market structure that the integrated firm can implement
downstream when it engages in production shifting.21 Assume that k = k and that U is merged
with the inefficient firm. Then, if the integrated firm's subsidiary is DS9 U can serve Dk at a unit
price equal to marginal cost. At this unit price, Ds remains inactive and the integrated firm can
extract the highest possible profits from the downstream market. Instead, if U is integrated with
20 Because n "'(C) is equal to m2i'q{{P{Q) - C)q], differentiating nm{C) twice with respect to C yields 3nm/dC =
-q< 0 and 327t'" /3C2 = -dq/dC > 0.
If it is merged with the efficient retailer, U can implement the monopoly outcome via foreclosure of the rival
retailer.
©RAND 2015.
FIGURE 3
Dk, then Dk stays active even if the rival obtains the good at marginal cost. Thus, the in
firm cannot extract the monopoly profits in this case.
This asymmetry arises because it is relatively more costly to keep an inefficient down
firm inactive when this firm has lower cost in absolute value. Indeed, if U is integrated
inefficient Ds , then Dsr s marginal cost of production is ¡1 -f X + c. If the firm is integrat
an inefficient Dk9 then Ą's marginal cost of production is ¡i + c. In the latter case, U mu
the unit price below c to keep its downstream unit inactive when X = X. As a conseque
distortion of the unit price is higher if U is integrated with Dk rather than Ds.
As these examples illustrate, both forces point in the same direction; that is, to make
integration with Ds more profitable, although in two extreme cases. Lemma 2 shows that
forces lead to the same conclusion for all values of X < X when p = 1/2 and the demand
What happens when p rises above 1 /2? Because the merger with Ds is profitable w
p = 1 /2, by a continuity argument, the same result holds true when p is (slightly) larg
1/2. As p increases, it is also more likely that the monopoly producer will be integrated
inefficient retailer and engage in output shifting. Can output shifting be so effective that i
the vertical merger with Ds profitable and procompetitive with respect to vertical sep
Proposition 4 addresses this question. The expressions for pVI and pc are given in the Ap
©RAND 2015.
Proposition 4. If p > pvl , the monopoly producer ( U ) integrates with retailer Dk and th
is anticompetitive in expectation. Instead, U integrates with retailer Ds if p < pVI . The
with Ds is procompetitive in expectation if p is also larger than pc , and anticompetitive oth
Proposition 4 shows that vertical integration can result in a procompetitive outco

expectation in a model with uncertainty over retailers' marginal costs of production. Spe
this result holds true if p lies in an intermediate range (i.e., pc < p < pVI). First, for v
of p below pK/, U finds it more profitable to merge with retailer DS9 which is less eff
expectation. Second, for values of p above p' the probability that the integrated firm en
output shifting is sufficiently high that the aggregate quantity in the vertically integrated
is larger than the quantity in the vertically separated industry.
We illustrate the results of Proposition 4 using a parametric example with a = ß =
c = ¡i = .25. The shaded area in Figure 3 shows when vertical integration with Ds is pr
and procompetitive in expectation. This can happen even for high values of p, and the i
relies on the same insights developed below Lemma 2. If, for instance, p is close to 1
close to À, then U-Ds can shift output to Dk at a unit price close to marginal cost. This al
integrated firm to implement an outcome close to the monopoly one on the downstream
This is more profitable than merging with Dk, because in that case shifting output to Ds
reducing the unit price below marginal cost (if Ds happens to be more efficient). Note th
results are not unique to a setting with linear demand. For example, vertical integration
is procompetitive and more profitable than a merger with Dk for values of p between 0.5
when using the demand function P(Q) = a - Qß together with the following parameter
a = 1, ß = 2, c = .2, ¡i = .3, and À = .2.
6. Conclusions
■ This article examines a standard model in which a monopoly producer dea

retailers by means of secret two-part tariffs. We show that a crucial element
is whether the retailers (downstream firms) have different marginal costs
central finding is that, when the upstream monopolist is integrated with the les
it will depart from the foreclosure strategy by reducing the unit price it offers
but more efficient retailer. This output-shifting effect makes vertical integra
when compared to vertical separation if the unintegrated retailer is sufficient
This shows that, for example, policies of divestiture imposed by regulatory a
foreclosure can have unintended consequences and may be misguided. Co
conclusions, Lafontaine and Slade (2007) document that studies assessing the
forced vertical separations generally find that these legal decisions lead to pr
Our results are robust to a setting with differentiated products. Moreover, w
in which the upstream monopolist's integration decision is taken under uncerta
marginal costs of production, reflecting the consideration that vertical integr
decision. There, we determine the conditions such that the monopoly produce
retailer that is less efficient in expectation and this merger gives rise to a proco
A crucial assumption in our setting is that the monopoly producer cannot com
integrated less efficient retailer. However, there are various reasons why an inte
not want to do so. For example, if the efficient unintegrated retailer has som
the integrated firm wants to keep its downstream affiliate active to improve its
vis-à-vis the independent retailer.22 Another reason could be that the down
allows the monopoly producer to capture valuable information about demand
it allows the upstream producer to sell other product lines.
22 In the web Appendix, we provide a formal analysis of this situation, using a bargaining ga
O'Brien and Shaffer (2005).
©RAND 2015.
Our results have implications for public policy formulation. Specifically, the model s
that vertical integration might not necessarily result in a foreclosure strategy when the integ
company deals with more efficient retailers - a claim that is reminiscent of the Chicago
argument against the anticompetitive theories of vertical integration and foreclosure. An
for future research could be to extend the analysis in this article to a framework where opport
for vertical mergers arise dynamically (e.g., along the lines of Nocke and Whinston, 2010
would allow to further study the conditions under which vertical integration is procompet
Appendix: The Appendix contains the proofs of Lemma 1-2 and Proposition
2-4.
□ Proof of Proposition 1. We solve the game by backward induction. In the last stage, retailer A produces qj(w¡, w-i
as defined by (1). Accordingly, one-to-one production technology implies that D, orders q¡(Wi, u/_,-) from the monop
producer U .
We now determine ř/'s tariffs. With passive beliefs, the equilibrium contract offered by U to each retailer D¡
must maximize their joint profits (McAfee and Schwartz, 1994). Therefore, U' s first-stage maximization problem can
written as
max qj(w¡, w-¡)(w¡ - c) + ( P(qi(Wi , &>_,) + <?_,) - - w^q^wj, u>_,).
Taking the first-order condition with respect to w, and invoking the Envelope Theorem, we obtain (functional notatio
dropped, for simplicity)
dq¡ d q¡
(">, - C)- + q, - q¡ = (Ulf - c)- = 0.
ÓW i ÖW i
Because dq¡ /3 w¡ < 0, at the equilibrium w¡ =

Cournot quantity, q' and q2 , to obtain Cournot p
Cournot profits by setting the fixed compone
Proof of Proposition 2. Note first, that when D2

in w2 for any wx. It follows that U-D2 s choo
maximize its profit given q' :
max(P(^! +q)~ ß2 -c)q.

i
The optimal solution results from the first-order condition P(Q) - ß2 - c + P'(Q)q2 = 0.23 Denote this solution by
qļ(q) ). Applying the Implicit Function Theorem yields
dq, 2P'Q)+ P"(Q)q2 [ 2 J

implying that q*2{-) is a strictly decreasing function. Technically, w2 is indeterminant. However, if D2 decides about q2 t
maximize its own profit, it requires the instruction by U that w2 = c.
We now turn to the optimal output choice of Dx . This choice is implicitly defined by P(Q) - ß' - W' + P'{Q)q' =
0. It follows that q'{w' , c) is strictly decreasing in w i, and we can define the inverse function ^1(^1) as the W' that solve
q' = qx(w',c). Then, the optimization problem of U-D2 when dealing with retailer Dx can be written as
max F' + {w'{qx) -c)qx + (P (<?, +<72*(^i)) ~ M2 - c)q*2(q 1),

</1
subject to
F' < (^(<7i + <?2(?i)) "Mi - û'(q'))qx. (A2)

At equilibrium, U-D2 formulates a take-it-or-leave-it offer to fully extract retailer D' 's profit.
is binding, and we can rewrite the optimization program o fU-D2 as
max (P {q{ + q*2(q')) - Mi - ¿>i(<7i))<?i +(Ai(?i) - c)qx + (P (qx + q*2(q 1)) -

</1
23 Because of our assumption P'{Q) + P"Q < 0, the second-order condition is satisfied.
©RAND 2015.
This can be rewritten as q¡ chosen to maximize
(P(q{ + q*2{q i)) - c) (q{ + q*2{q')) ~ Mitfi ~ ßiq2(q'),
which is industry profit. Using the Envelope Theorem, the first-order condition is
P' {<i' +<?2(<7i))<7I + ~dq^) + M2 ~Mi =0- (A3)

We show below that the second-order condition is satisfied. As dq*2/dqx e [- 1/2, -1), it follows t
1 + dq'¡dqx > 0. Hence, (A3) yields q* > 0 if and only if ¡jl2 > Mi-
We now turn to the second-order condition. Taking the derivative of the first-order condition (A3) with respec
q 1 yields
0 + d~dq ) (p + p'q' +<?2(<7i))) + < (A4)

where d2q¡/dq2, as determined from (Al), is equal to
d2q-_ = P'(Q') [2 qļ(q , )( P"( Q' ))2 + P'( Q' )( />"( Q' ) - q'(q , ) P"'( Q' ))]
(2P(0-)+ P"(Q']q1(q¡)f
with £?* = q] + q*2{q'). Inserting the last equation into (A4), and ignoring functional arguments, yields
(P')2 [4 (P')2 + (P"?qH 3?1 +?2") + P'QP"q> +4P"q¡ - P"'q ,q'2)'

. t (Aj)
(2 P' + P
Because P' + P"

negative, which
the second-order condition is satisfied.
Proof of Proposition 3. To determine iuj, we use the first-order conditions for q' and q2. They imply q' = -(P(Q*) -
Mi - w])/ P'(Q*) and q' = -(P{Q*) - M 2 - c)/ P'(Q*). Plugging these expressions together with dq'ļdq' into (A3)
and rearranging yields
■ -, , , P"(Q')(Pl - ß,)(P(Q')~C- ß2) /A£,

wt ■ = P(Q)-2ß2+ßt -, , + ,
Then, w* < c if and only if
> > (P(Q')~ ßi-c)(P'(Q-

ß2 ß' > > (P (Q-)Y - (P(Q-)
If w' is sufficiently smaller than c, the value
affiliate is inactive. Therefore, the first-orde
/Lt, - w' + P'q')q' = 0, yielding w* = M2
Finally, note that changes in the aggregate
D2 obtains the intermediate good at a per-unit
first-order conditions for the downstream qu
_
dwļ dw 1 3w' 3 P'(Q*) + Q P"(Q*)
Because dQ*/3w' < 0, aggregate output is larger under vertical integration than under vertical separation if
w * < c.
Proof of Lemma 2. Note that our assumption that firms are both active when receiving the input at marginal cost imp
that À < À = (a - c - m)/2. So we assume that this condition holds in this proof. To begin with, we determine the prof
of the vertically integrated firm when U merges with Dk, the retailer whose marginal cost of production is certain a
equal to ļi.
□ U merges with Dk. With probability p, retailer Dk is the more efficient retailer. Thus, the results in Proposition 1
apply: the upstream unit of the integrated firm forecloses retailer Ds 's access to the intermediate good, and the downstream
unit produces the monopoly quantity. Using the assumption of linear demand, the quantity and the profit of the integrated
firm U-Dk in this state are equal to (a - c - ¡i)/ 2ß and (a - c - ß)2 /Aß, respectively.
©RAND 2015.
With probability 1 - p, retailer Ds has the lower marginal cost of production ß - k < ß. U sets the internal tr
price equal to its marginal cost of production (c) and a unit price ws as in (A6) as long as Dk is active. Invoking li
demand yields
a + c - ß - 4k
W' =
The quantity produced by r
a - c - fi - 2k 2k
«' =
The quantity of the integrated firm's downstre

(H",,,) are given by
(a-c-pf (a-c-ßf + Ak1 (a - c - pf + 4(1 - >o)X2

'
For p = 1/
□ U merges
this case, pr
are
2k a - c - ļi - 3k
gk = j and *, =
Then, the profit of U-Ds is
(a - c - fi)2 - 2 k(a -
4ß '
The value of qs is positive if and

This gives equilibrium quantities o
a-c-ß-k
qk =
and U-Ds' s profit equal to
k(a - c - ļi - k)
ß '
With probability 1 - p, retailer Ds is more effici

D*'s access to the intermediate good, and the dow
equilibrium value of D/s quantity and the profit
(a - c - ß + k)2/4ßy respectively.
In sum, the expected profits of U-Ds {ī'y'_Ds ) are
(a - c - ß + A.)2 - 4 kp(a - c - ß
4^
if k < k, and
(a - c - ß + k)2 - [(a - c - ß)(a - c - 2k - ß) + 5À2]p

4ß
for k e (î, k).

If p = 1/2, these expressions reduce to
[[{a-c- ß)2 + 3 k2] /4ß if A. < X,

ļ [(a - c - ß)(a - c - ß + 6k) - 3k2] /8ß if ke (k, k).
At p = 1/2, the difference between n vvl_Dx and n 'J_Dk is strictly positive for all values of k e (0, k), which establishes
the claim in the proposition.
©RAND 2015.
Proof of Proposition 4. We start by determining the threshold above which a merger with Dk is more profitable
merger with Ds. Using the values of n^D and n ¡ýl_D obtained in the proof of Lemma 2, we find that
X[2(a-c-ß-2X) + X-4p(a-c-ß-2X)] .r
4ß
n Vl - n Vl =
U~Ds U~Dk (1 - p)[(ot - c - ii + X)2 -4X2]-(a - c - ß)2 +4Xp(a - c - ß - X) ,c
- II AG ^ (A, A.).
It follows that n v'_Dk > n y'_Dx if and onl
- +
2 4(a - c - ß - 2X)
P>P =
A.[2(a - c - ß) - 3X] r T
-
(a - c - ¡i - xy
We next analyze whether vertical integration between U and Dk is procompetitive. Determining the aggregate expected
quantity under vertical separation and under vertical integration between U and Dk, we obtain
vs = 2ct-2c-2ļi + X(' -2 p) an Vl __ (X-C-11 + 2X(' - p)

U = 3)8 an u~Dk __ 2ß
The difference between QyLDk and Qvs is equal to
4X - (a - c - ļi) - 2 Xp
60 '
implying that Q^'_Dk - Qvs > 0 if and only if
4 X-(a-c- /i) a-c- [i

P p - < 7r =
P p - < 7r =
If p" were to lie above pVI , then there wo

procompetitive. We find that
55e < py¡ VX < X,
implying that the merger between U and D

Finally, we establish the condition such th
quantity when U is integrated with Ds is e
i a - c - u + X -
26
Ovl_ U °s =
U °s oe + X-('+p)(ii + c) + p(a-3X) if X r-
2ß
Then, the difference between Qy'_Ds and Qvs is positive if and only if
(oí - c - ix - X „ -
P>PC= ,
a - c - u - X , - -
. Ī7
Ī7 3(a - c - ¡i - X) ^ - 2X
It is easy to show that pc < pvl for all values of X such that
Itf-v'SXa-c-iO.xj.
Therefore, the merger between U and Ds is procompetitive if p lies in the in
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Vol.61 (1971), pp. 112-123.
©RAND 2015.

Vertical and Horizontal Integration

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Vertical and Horizontal Integration

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Vertical integration, foreclosure, and productive efficiency

Author(s): Markus Reisinger and Emanuele Tarantino

Vertical integration, foreclosure,

* WHU - Otto Beisheim School of Management; markus.reisinger@whu.edu.

Copyright ©2015, RAND. 461

■ An upstream firm, U , is a monopoly producer of an intermediate good

Each retailer produces a quantity of q¡ , i = 1,2, resulting in an aggregate retail output

Afterward, retail purchases are made, and profits are realized.

q™ = arg max ( P(q ) -c- /i^q,

whereas n™ denotes retailer D¡ 's monopoly profit when producing q !" :

7 t!" = max ( P(q ) - c - ßi)q.

The Cournot equilibrium is the solution to the system

q i = arg max (P(q + q2 ) - w] - ß{)q and q2 = arg max (P(q] + q) - w2 - fi2)q.

< = (p (tí + tí-) ~c~ Pi) tí 0)

Proposition 1. Suppose the upstream monopolist U is integrated with retailer Dx . In equilib

LINEAR DEMAND EXAMPLE

LINEAR DEMAND EXAMPLE

c _ (4ß2 + y2)y(tt -c-ļJL i - A) + 8 ß3c - 2ßy2(2a + c - 2 ļix)

Retail price competition . We now analyze whether

15 The value of wf when the integrated unit is inactive is equ

16 For the figure, we use the following parameter values: a =

B _ {Aß2 + y2)y{ a - c - ßx - A) + 8 ß3c + 2ßy2(2a + 3 c - 2¡ix)

5. Vertical merger under uncertainty

17 Instead, with passive beliefs, if an equilibrium exists, it leads to a unit pr

I. The monopoly producer U decides whether to merge with retailer Dk or Ds.

^[j īm(ļl - k + C) + 7Tm(ļl + k + c)] - nm(ļi + c),

LINEAR DEMAND EXAMPLE

Proposition 4 shows that vertical integration can result in a procompetitive outco

■ This article examines a standard model in which a monopoly producer dea

max qj(w¡, w-¡)(w¡ - c) + ( P(qi(Wi , &>_,) + <?_,) - - w^q^wj, u>_,).

Because dq¡ /3 w¡ < 0, at the equilibrium w¡ =

Proof of Proposition 2. Note first, that when D2

max(P(^! +q)~ ß2 -c)q.

dq, 2P'Q)+ P"(Q)q2 [ 2 J

max F' + {w'{qx) -c)qx + (P (<?, +<72*(^i)) ~ M2 - c)q*2(q 1),

F' < (^(<7i + <?2(?i)) "Mi - û'(q'))qx. (A2)

max (P {q{ + q*2(q')) - Mi - ¿>i(<7i))<?i +(Ai(?i) - c)qx + (P (qx + q*2(q 1)) -

This can be rewritten as q¡ chosen to maximize

(P(q{ + q*2{q i)) - c) (q{ + q*2{q')) ~ Mitfi ~ ßiq2(q'),

P' {<i' +<?2(<7i))<7I + ~dq^) + M2 ~Mi =0- (A3)

0 + d~dq ) (p + p'q' +<?2(<7i))) + < (A4)

(P')2 [4 (P')2 + (P"?qH 3?1 +?2") + P'QP"q> +4P"q¡ - P"'q ,q'2)'

Because P' + P"

■ -, , , P"(Q')(Pl - ß,)(P(Q')~C- ß2) /A£,

Then, w* < c if and only if

> > (P(Q')~ ßi-c)(P'(Q-

The quantity produced by r

The quantity of the integrated firm's downstre

(a-c-pf (a-c-ßf + Ak1 (a - c - pf + 4(1 - >o)X2

Then, the profit of U-Ds is

The value of qs is positive if and

and U-Ds' s profit equal to

With probability 1 - p, retailer Ds is more effici

(a - c - ß + k)2 - [(a - c - ß)(a - c - 2k - ß) + 5À2]p

for k e (î, k).

[[{a-c- ß)2 + 3 k2] /4ß if A. < X,

It follows that n v'_Dk > n y'_Dx if and onl

vs = 2ct-2c-2ļi + X(' -2 p) an Vl __ (X-C-11 + 2X(' - p)

implying that Q^'_Dk - Qvs > 0 if and only if

4 X-(a-c- /i) a-c- [i

If p" were to lie above pVI , then there wo

55e < py¡ VX < X,

implying that the merger between U and D

max F' + {w'{qx) -c)qx + (P (<?, +<72(^i)) ~ M2 - c)q2(q 1),

max (P {q{ + q2(q')) - Mi - ¿>i(<7i))<?i +(Ai(?i) - c)qx + (P (qx + q2(q 1)) -

(P(q{ + q2{q i)) - c) (q{ + q2{q')) ~ Mitfi ~ ßiq2(q'),