Vertical integration

ANNA CRETI
ANNA.CRETI@DAUPHINE.PSL.EU
 Vertical Non-Integration
2

Supplier 1 Supplier 2 Supplier 3 Upstream

The Firm

Distributor Distributor Distributor

1 2 3 Downstream

Consumers
 Vertical Integration
3

Supplier 1 Supplier 2 Supplier 3 Upstream

The Firm

Distributor 1 Distributor 2 Distributor 3 Downstream

Consumers
 Problems in vertically related industries
4

1. Double marginalization

2. Threat of vertical foreclosure

3. Hold-up & other bargaining problems

 Problems in vertically related industries
5

1. Double marginalization

2. Threat of vertical foreclosure

3. Hold-up & other bargaining problems

Double marginalization and with no-
integrated firms
◼ Problem of the double marginalization (successive mark-up
problem).

◼ An example:

❑ 1 upstream and 1 downstream monopolist (e.g. manufacturer

and retailer).

❑ The upstream firm has MC=c → sells its product to the

retailer at retail price r per unit.

❑ The retailer has no other costs → also assume one unit of

input gives one unit of output.

❑ The retail demand is P = A – BQ

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Benchmark: no-integration

Marginal Manufacturer
costs c

wholesale price r

Price P

Consumer Demand: P = A - BQ

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Benchmark: no-integration
◼ Consider the retailer’s decision
❑ Identify profit-maximizing output.
❑ Choose the profit maximizing price.  marginal revenue downstream is MR
= A – 2BQ
Price  marginal cost is r

 equate MC = MR to give the

A quantity Q = (A - r)/2B
Demand
 identify the price from the demand
curve: P = A - BQ = (A + r)/2
(A+r)/2
 profit to the retailer is (P - r)Q which
is πD = (A - r)2/4B
r MC profit to the manufacturer is (r-c)Q
which is πM = (r - c)(A - r)/2B
MR Quantity
A-r A/2B A/B
2B
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Benchmark: no-integration

 Suppose the manufacturer sets a

Price different price r1
A  Then the downstream firm’s
Demand output choice changes to the output
Q1 = (A - r1)/2B

r1
 and so on for other input prices
 demand for the manufacturer’s
r MC output is just the downstream
Upstream Demand
marginal revenue curve

MR
A - r A/2B A/B
Quantity
A - r1 2B
2B

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 Benchmark: no-integration
 the manufacturer’s marginal cost is c
 upstream demand is Q = (A - r)/2B which
is r = A – 2BQ
 upstream marginal revenue is, therefore,
Price MRu = A – 4BQ
 equate MRu = MC: A – 4BQ = c
A
 so Q*=(A-c)/4B the input price is (A+c)/2
(3A+c)/4
 while the cons. (retail) price is (3A+c)/4
Demand
(A+c)/2  the manufacturer’s profit is (A-c)2/8B

 the retailer’s profit is (A-c)2/16B

Upstream demand

c MC
MRu MR
A/4B A/2B A/B
Quantity
(A-c)/4B

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Vertical integration-merger
◼ Suppose that the retailer and manufacturer merge.
❑ Manufacturer takes over the retail outlet.
❑ Retailer is now a downstream division of an integrated firm.
❑ The integrated firm aims to maximize total profit.
❑ Suppose that the upstream division sets an internal (transfer) price
of r for its product.
❑ Suppose that consumer demand is P = P(Q).
❑ Total profit is: The internal transfer
◼ Upstream division: (r - c)Q price nets out of the
profit calculations
◼ Downstream division: (P(Q) - r)Q
◼ The aggregate profit: (P(Q) - c)Q

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Vertical Merger …
 the integrated demand is P(Q) = A - BQ
This merger has  marginal revenue is MR = A – 2BQ
benefited theThis
two merger has
 marginal cost is c
Price firmsbenefited consumers
 so the profit-maximizing output requires
that A – 2BQ = c
A  so Q* = (A – c)/2B
 so the retail price is P = (A + c)/2
Demand  aggregate profit of the integrated firm is
(A+c)/2 (A – c)2/4B

Retail Price
( A + c )  (3A + c ) ; A  c
c 2 4
MC ( A − c)  ( A − c) + ( A − c)
2 2 2

MR Quantity Profit
4B 8B 16 B
(A-c)/2B A/B 4( A − c) 3( A − c )
2 2


16 B 16 B

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Vertical Merger …
◼ Vertical merger (integration) increases profits and consumer surplus
→ How?
❑ Firms have some degree of market power (successive monopoly) →
when separated set P>MC.
❑ Integration removes double marginalization.
◼ What if manufacture were competitive?
❑ The retailer plays off manufacturers against each other → obtains
input at MC.
❑ The retailer obtains the integrated profit without integration.
◼ Why worry about vertical integration?
❑ ….vertical foreclosure.

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 Problems in vertically related industries
14

1. Double marginalization

2. Threat of vertical foreclosure

3. Hold-up & other bargaining problems

 Vertical Foreclosure
15

 Market power in one stream can be extended to

another through vertical foreclosure.

U1 U2

D1 D2 D3
 Vertical Foreclosure
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U1 U2

D1 D2 D3

D2 and D3 at cost disadvantage, since U2 has market power.

U2 may not do as well as U1 because of double marginalization.
Vertical Merger & Foreclosure
◼ Vertically integrated firm may refuse to supply other firms → so
integration can eliminate competitors (anti-competitive).

 suppose that the seller is supplying

three firms with an essential input

 the seller integrates with one buyer

 if the seller refuses to supply the other

buyers they are driven out of business

 is this a sensible thing to do for the

integrated firm?

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Vertical Merger & Foreclosure
◼ Vertical foreclosure may reduce competition → offsets benefits of
removing double marginalization.

◼ But for this to work:

❑ Foreclosure has to be a credible strategy for the merged firms.

❑ Foreclosure must be subgame perfect.

◼ Consider two models of foreclosure:

❑ Salinger (1988) with Cournot competition.

❑ Ordover, Saloner and Salop (1990) with Bertrand competition.

◼ Example: Suppose that there are some integrated firms (i) and some
independent upstream and downstream producers (n).

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Vertical Merger & Foreclosure
Profit of an integrated firm:  = ( P − cU − cD ) qDi
I D
◼

Profit of an independent upstream firm:  = ( P − cU ) qU n

U U
◼

◼ Profit of an independent downstream firm:  D = ( P D − PU − cD ) qDn

◼ The integrated firm will neither source nor sell in the independent
market.

◼ For the independent upstream firms to survive requires: PU − cU  0

◼ The downstream unit of an integrated firm obtains input at cost cU.

◼ Buying from an independent firm costs PU>cU → thus, the

downstream division will not source input externally.

◼ Now, suppose that an upstream division of an integrated firm is selling

to independent downstream firms, it earns PU - cU on each unit sold.

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Vertical Merger & Foreclosure
◼ Divert one unit to its own downstream division: this leaves the
downstream price unchanged → it earns PD - cU - cD on this unit
diverted.

◼ An independent downstream firm to survive requires: PD - PU - cD > 0.

◼ Thus for, PD - cU – cD > PU – cU, we require PD - PU - cD > 0.

◼ Hence, the upstream division will not sell the input externally (to
independent downstream firms).

◼ Foreclosure exists → although it may not necessarily be always harmful:

❑ It reduces the number of buyers in the upstream market.
❑ It increases prices charged by independent sellers to non-integrated
downstream firms, but integrated downstream divisions obtain input at cost.
❑ It puts pressure on non-integrated downstream firms.

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Vertical Merger & Foreclosure
◼ If there are “enough” independent upstream firms, the anti-competitive
effects of foreclosure will be offset by the cost advantages of vertical
integration (elimination of double marginalization).
◼ There are also strategic effects that may prevent foreclosure → Ordover,
Saloner and Salop (1990) → OSS.
◼ Example: 2 downstream and 2 upstream firms. → downstream
firms make differentiated products → upstream firms make
homogeneous products.
◼ Firms engage in price competition.
◼ Suppose that U1 merges with D1, suppose also that they credibly refuse
to supply D2. Hence, U2 is a monopoly supplier to D2.
◼ U2 and D2 set prices → reflect double marginalization → so they may
well choose to merge also, but U1 and D1 can foresee this and so may
choose not to merge.

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Vertical Merger & Foreclosure
◼ The Comp Analysis analysis thus far, requires that there is no other
source of the input supply. If there is such a source this will constrain
U2’s price → may make merger of U2 and D2 less likely.

◼ Also, U1&D1 may try to undermine the merger another way, e.g.:
❑ By offering to supply D2 undercutting U2.
❑ Setting a price such that U2 and D2 have no incentive to merge.
❑ Thus, there will be no complete foreclosure.

◼ Note that there is a timing problem with this analysis:

❑ U1 and D1 decide whether or not to merge.
◼ If they do not, the market continues as is.
◼ If they do, they seek to undermine a merger of U2 and D2.
❑ But if U1 and D1 don’t merge U2 and D2 have a strong incentive to merge

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Alternative Solutions to Vertical Merger
◼ Vertical merger is just one solution to remove the double marginalization → it
may be costly if we consider the fact that merger is costly.

◼ Other alternative solutions → the upstream firm can impose vertical

restrictions (restraints):

❑ Vertical price restraints: → e.g. resale price maintenance (RPM) → retailer

agrees to sell at manufactured specified price.

❑ Restrictions on the right of retailers:

◼ Cannot carry other brands → exclusive dealing.

◼ Exclusive territory.

❑ Franchising.

❑ Others …

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 Problems in vertically related industries
24

1. Double marginalization

2. Threat of vertical foreclosure

3. Hold-up & other bargaining problems

 Hold-ups & Bargaining Issues
25

 Firms often need to make transaction-specific investments.

 E.g., a mold built to stamp out GM fenders can’t be used for
Ford fenders.
 This creates the danger of hold-up (opportunism).
 After one firm (e.g., Fisher Body) makes investment,
investment is sunk and subsequent bargaining w/ other
firm (e.g., GM) could lead to returns that are too low.
 Example
26
 Upstream invests €12 million on transaction-specific
investment.
 MC for upstream for parts is € 10.
 A million units to be traded.
 Downstream’s value is € 30/part.
 Surplus from post-investment trade = € 20/unit.
 Suppose bargaining splits surplus evenly, then upstream
gets paid € 20/unit; so gross profit is € 10 million.
 But this is less than investment cost!
 Contractual Solutions
27

 Obviously, should fix price in advance at € 22 or more per

part!
 But in many cases this will create agency problems.
 If quality, delivery time, etc., matter, what incentive does upstream now
have to do good job given guaranteed price?
 But w/o guaranteed price, upstream subject to hold-up.
 Example: Disney & Pixar
28

 Disney wants Pixar to make computer-animated film, Toy

Story, which Disney will market.
 Given Disney’s expertise in mkt’ing animated films,
relationship makes sense.
 What contract to write?
 Disney & Pixar (cont.)
29

 If Disney fixes price in advance, then Pixar’s incentives are

blunted.
 If parties wait to negotiate price after Pixar produces film,
then Pixar’s incentives better, but now problem of hold-up.
 Possible solution: option contract.
 Option Contract
30

 Contract fixes price if trade, but gives Disney right to refuse

to trade.
 If Pixar doesn’t make sufficiently good film, then Disney
lets its option to buy expire.
 If Pixar does make sufficiently good film, then Disney will
want to exercise.
 Renegotiation
31

 A problem with any contract is that it can be renegotiated.

 Hence, if outcome arises in which exercising contract as
written would leave surplus on table, then parties will
renegotiate.
 However, the anticipation of renegotiation can distort ex
ante incentives.
 Renegotiation
32

 This can undo the option-contract solution

 What ultimately matters is which of two effects dominates

 hold-up effect

 threat-point effect
 Threat-point Effect
33
 Our assumption of wholly specific investment is often
unrealistic—good could have a lower, general value (e.g.,
Warner Bros. could mkt. Toy Story).
 Does value increase more at margin w/ investment than
specific value?
 If so, threat-point effect dominates and efficiency can be
achieved.
 An individual’s threatpoint is the payoff they can guarantee
themselves by not participating in a bargain.
 If not, hold-up effect dominates and inefficient outcome.
 Other Solutions to Hold-up
34

 Keep markets thick:

 harder to be held up if you have alternative suppliers or distributors to
use.
 additional benefits of diversification (e.g., not hosed if supplier’s
factory burns down).
 Develop reputation for cooperation rather than
opportunism.
 works if PDV of cooperate > PDV of opportunism today and non-
cooperation tomorrow.
 Reputation
35

payoff

cooperate

opportunistic

time
0 1 2 ...
 Merge to Avoid Hold-up
36

 Merger serves to limit danger of hold-up

 Merger, however, doesn’t miraculously cure agency
problems.
 still need to provide incentives to upstream & downstream managers
 dangers in how this is done (e.g., could be mistake to turn upstream
into profit center—usually better to make cost center).
 Business alliances can also do the job
 They require intensive coordination