Vertical merger

1. Consider an industry with one upstream and n downstream …rms. The

downstream …rms produce a homogeneous product using the input sold by
the upstream monopolist. One unit of the input is necessary to produce
one unit of the …nal (homogeneous) good. The upstream …rm produces
the input at a constant marginal cost of 10 per unit and sells the input
to the downstream …rms at a unit price w. The downstream …rms have
no other costs (apart from the cost of buying the input) and compete á
la Cournot. Demand for the …nal good is given by an inverse demand
function
p = 150 Q;
where Q is total quantity.
(a) Find the subgame perfect Nash equilibrium in the game where the
upstream …rm chooses the input price before the downstream …rms
choose quantities.
Solution: We solve by backwards induction. In the second stage, there
is a symmetric Cournot game between n …rms. The problem of Firm
1 is
max D
1 = (150 Q w) q1:
q1
The …rst-order condition is
@ D1 = 150 2q1 (q2 + q3 + ::: + qn) w = 0:
@q1
By symmetry, q1 = q2 = ::: = qn = q , yielding

150 2q (n 1) q w=0
()
150 w
q= :
n+1
Total demand from the downstream …rms is then
n
Q = nq = (150 w) :
n+1
At stage 1, the problem of the upstream …rm is
n
max U = (w 10) (150 w) :
w n+1
The …rst-order condition is
@ U n
= (150 w (w 10)) = 0
@w n+1
()
w = 80:
 This gives downstream demand of
n 70n
Q= (150 80) = :
n+1 n+1
The downstream price is therefore
70n 80n + 150
p = 150 = :
n+1 n+1

(b) Assume that the upstream …rm monopolizes the industry by acquiring
one of the downstream …rms (vertical integration) and stop supplying
the input to the other downstream …rms. Show that such an acquisition
is always pro…table.
Solution: Vertical integration between the upstream …rm and one
downstream …rm implies that the integrated …rm is a monopolist solv-
ing the following problem:
max I = (150 Q 10) Q:
The …rst-order condition is
@ I
= 150 2Q 10 = 0
@Q
()
Q = 70:
The consumer price is then

p = 150 70 = 80:
This gives the integrated …rm a pro…t of

I = (80 10) 70 = 4900:

Under vertical separation, the pro…t of the upstream …rm is
70n n
U = (80 10) = 4900;
n+1 n+1
 and the pro…t of each downstream …rm is
D 80n + 150 70 4900
i = 80 = 2
:
n+1 n+1 (n + 1)
The sum of the pro…ts of the upstream and one downstream …rm is

n2+n+1
D n 4900
U + i = 4900 + 2
= 2
4900:
n+1 (n + 1) (n + 1)
The pro…tability of the merger is therefore

D
n2 + n + 1 4900n
I U + i = 4900 4900 = > 0:
(n + 1)2 2n + n2 + 1

(c) What is the e¤ect of vertical integration on the …nal consumer price?
 Solution: The e¤ect of vertical integration on the consumer price is
80n + 150 70
pI pS = 80 = < 0:
n+1 n+1
Thus, the consumer price goes down as a result of vertical integration.

(d) Show that the double marginalization problem decreases with n and
disappears when n ! 1. Explain.
Solution: Using the equilibrium consumer price under vertical separa-
tion, we derive

@ 80n+150
n+1 70
= 2
<0
@n (n + 1)
and
80n + 150
lim = 80 = pI :
n!1 n+1
Thus, the equilibrium consumer prices under vertical separation and
vertical integration are equal when n ! 1. In other words, perfect
competition in the downstream market eliminates the double marginal-
isation problem.
2. A manufacturer sells its product through a retailer. The manufacturer can
produce the good at a cost of 10 euros per unit and sells the product to
the retailer at a price of w euros per unit. In addition to the cost of buying
the product from the producer, the retailer has a distribution cost of 5
euros per unit sold. There are no …xed costs. Demand for the product is
given by the inverse demand function

p = 105 Q;
where p is the retail price and Q is total quantity. Consider the following
two-stage game: (i) The manufacturer chooses the producer price w, then
(ii) the retailer chooses how many units to buy from the manufacturer and
sell to consumers.

(a) Derive the subgame perfect Nash equilibrium and …nd the equilibrium
producer and retail prices and the equilibrium quantity.
Solution: We solve the game by backwards induction. At the second
stage, the retailer solves
max D = (105 Q w 5) Q:
Q
The …rst-order condition is
@ D
= 105 2Q w 5=0
@Q
()
w
Q = 50 :
2
At stage 1, the producer solves
w
max U = (w 10) 50 :
2
The …rst-order condition is
@ U w 1
= 50 (w 10) = 0
@w 2 2
 ()
w = 55:
This gives a quantity produced of
55
Q = 50 = 22:5
2
and a retail price of

p = 105 22:5 = 82:5:

(b) Show that the manufacturer and the retailer could both be better o¤
by integrating vertically.
Solution: Under vertical separation, the pro…ts of the producer and
retailer are, respectively,

U = (55 10) 22:5 = 1012:5

and

D = (82:5 55 5) 22:5 = 506:25:

If the two …rms merge, the integrated …rm solves the following problem

max I = (105 Q 15) Q:

Q
The …rst-order condition is
@ I
= 90 2Q = 0
@Q
()
Q = 45:
This gives a retail price of

p = 105 45 = 60
and a pro…t of

I = (60 15) 45 = 2025:

The merger is pro…table, since

I ( U + D ) = 2025 (1012:5 + 506:25) = 506:25 > 0

3. Consider the same market description as in Exercise 2, but suppose that
there are two independent retailers in the downstream market instead of
just one. Suppose also that the manufacturer sets the same price for both
retailers, and suppose that there is no horizontal di¤erentiation between
the two retailers, so that the same product o¤ered by di¤erent retailers is
considered to be homogeneous by consumers.

(a) Derive the subgame perfect Nash equilibrium and …nd the producer and
retail prices, and the equilibrium quantity, under each of the following
two assumptions:

i. the retailers compete in prices (Bertrand).

Solution: If the retailers compete in prices, the Nash equilibrium in
the second-stage game is

p 1 = p 2 = w + 5:
Total demand facing the producer is then

Q = 105 (w + 5) = 100 w:
The producer then solves

max U = (w 10) (100 w) :

w
The …rst-order condition is
@ U
= 100 w (w 10) = 0
@w
()
w = 55:
So the equilibrium retail price is

p1 = p2 = 55 + 5 = 60:
ii. the retailers compete in quantities (Cournot).
Solution: In the case, the second stage subgame is a Cournot duopoly.
The problem of retailer 1 is

max D
1 = (105 q1 q2 w 5) q1:
The …rst-order condition is
@ D1 = 100 2q1 q2 w = 0:
@q1
By symmetry, q1 = q2 = q , yielding

100 3q w=0
()
100 w
q= :
3
Total demand is therefore
200 2w
Q = 2q = :
3
At the …rst stage of the game, the producer solves
200 2w
max U = (w 10) :
w 3
The …rst-order condition is
@ U 200 2w 2
= (w 10) = 0
@w 3 3
()
w = 55:
Total demand is then
200 2 (55)
Q= = 30;
3
 so the retail price is

p = 105 30 = 75:

(b) How does downstream competition a¤ect the incentives for vertical
integration? Does it matter if the retailers compete in prices or quan-
tities? Show and explain.
Solution: Downstream competition reduces the equilibrium retail price
from 82:5 to 60 (under Bertrand competition) or to 75 (under Cournot
competition), thus reducing the incentives for vertical integration. Un-
der Bertrand competition, the incentives for vertical integration is com-
pletely eliminated, since the equilibrium retail price is equal to the retail
price under vertical integration (i.e., no double marginalisation). Under
Cournot competition, the incentives for vertical integration is reduced
but not eliminated, since the equilibrium retail price is still higher than
the retail price under vertical integration.
4. Suppose that there is a single producer of cheese, called C . In order to
produce the cheese, the …rm C needs to buy milk from the …rm M , which
is the only producer of milk. M can produce milk at a cost of 2 euros
per unit, and sells the milk to C for a price of pM per unit. Firm C
can transform two units of milk into one unit of cheese without any extra
costs (apart from the cost of the milk). The demand for cheese is given
by QC = 20 pC , where pC is the price per unit of cheese.

(a) Suppose that the two …rms play the following two-stage game: Stage
1 : M chooses a price pM per unit of milk. Stage 2 : C observes this
price, chooses how much cheese to produce, and buys the necessary
amount of milk from M . Find the subgame perfect Nash equilibrium:
the price and quantities of milk and cheese, and the pro…ts of M and
C.
Solution: We …nd the equilibrium by backwards induction, starting at
Stage 2 of the game. Since C needs two units of milk to produce one
unit of cheese, the marginal cost of cheese production is 2pM . The
pro…t-maximisation problem of C is therefore
max C = (20 QC 2pM ) QC :
The …rst-order condition is
@ C
= 20 2QC 2pM = 0:
@QC
Solving for QC , this yields
QC = 10 pM :
If the price per unit of milk is pM , the amount of milk that C wants
to buy from M is therefore
QM = 2QC = 20 2pM :
At Stage 1, M solves the following problem:
max M = (pM 2) (20 2pM ) :
pM
The …rst-order condition is
@ M
= 20 2pM 2 (p M 2) = 0;
@pM
yielding
pM = 6 :
The demand for milk is therefore

QM = 20 (2 6) = 8:
The produced quantity of cheese is
QM
QC = = 4;
2
so the price of cheese is

pC = 20 4 = 16:
 The pro…ts of M are

M = (6 2) 8 = 32;
and the pro…ts of C are

C = (16 4) (6 8) = 16:

(b) Suppose that C and M vertically integrate and become one …rm. How
does this a¤ect the production of milk and cheese? What are the
equilibrium pro…ts of the vertically integrated …rm? Is the merger prof-
itable?
Solution: The integrated …rm can produce cheese at a marginal cost
of 4 (production cost per unit of milk times the number of units needed
to produce one unit of cheese). The pro…t-maximisation problem of
the integrated …rm is therefore
max I = (20 QC 4) QC :
Q C
The …rst-order condition is
@ I
= 16 2QC = 0;
@QC
yielding
QC = 8:
Thus, vertical integration implies that the production of milk and
cheese doubles. The price of cheese therefore reduces to

pC = 20 8 = 12:
The pro…t of the integrated …rm is

I = (12 4) 8 = 64:
The merger is clearly pro…table, since total pro…ts increases from 32 +
16 = 48 to 64.
(c) Suppose that there is a second producer of exactly the same type of
cheese. The two cheese producers have the same technology and costs,
buy milk from the same …rm (M ), and engage in (Bertrand) price
competition with each other. In this case, what would be the e¤ect of
vertical integration between the milk producer and one of the cheese
producers?
Solution: If the downstream cheese producers o¤er homogeneous prod-
ucts, Bertrand competition would ensure that the equilibrium prices
are equal to marginal cost. Thus, each cheese producer will set a price
given by
p C = 2 pM :
This means that, with a milk price of pM , the total production of
cheese will be
QC = 20 pC = 20 2pM
and the total demand for milk will be

QM = 2QC = 40 4pM :
The pro…t-maximisation problem of the milk producer is therefore:

max M = (pM 2) (40 4pM ) :

pM
The …rst-order condition is
@ M
= 40 4pM 4 (p M 2) = 0;
@pM
yielding
pM = 6 :
The price of cheese will then be

pC = 2pM = 12;
so the total production of cheese is

QC = 20 12 = 8
and total production of milk is

QM = 2QC = 16:
The two downstream cheese producers earn zero pro…ts, while the up-
stream milk producer earns a pro…t of

M = (6 2) 16 = 64:
Thus, Bertrand competition in the downstream market completely elim-
inates the double marginalisation problem and yields the same market
outcome as under vertical integration.