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UA UB
Possible Contracts
• Bilaterality
– As terms of other pairs are unobserved by at least
one member of a pair, supply terms cannot be
made contingent upon other supply contract terms
• Network Observability
– As the network state is publicly observed supply
terms can be made contingent on the network state
– Example:
• q11(1A,1B,2A,2B) = 3 and t11(1A,1B,2A,2B) = 2 and
q11(1A, 2A,2B) = 4 and t11(1A, 2A,2B) = 5 and so on.
Extensive Form
• Fix an order of pairs (in this case 4)
– Precise order will not matter for equilibrium we focus on
• Each pair negotiates in turn
– Randomly select Di or Uj
– That agent, say Di, makes an offer {qij(K), tij(K)} for all possible K
including Di and Uj.
• If Uj accepts, the offer is fixed and move to next pair
• If Uj rejects,
– With probability, 1-σ, negotiations end and bargaining recommences over the
new network K –ij.
– Otherwise negotiations continue with Uj making an offer to Di.
• Binmore-Rubinstein-Wolinsky bilateral game embedded in a
sequence of interrelated negotiations
– Examine outcomes as σ goes to 1.
Beliefs
• Game of incomplete information
– Need to impose some structure on out of equilibrium
beliefs
– Issue in vertical contracting (McAfee and Schwartz;
Segal) in that one party knows what contracts have been
signed with others and offer/acceptance choices may
signal those outcomes
• Simple approach: impose passive beliefs
– Let {qˆij ( K ), tˆij ( K )}ij , K be the set of equilibrium agreements
– When i receives an offer from j of qij ( K ) qˆij ( K ) or tij ( K ) tˆij ( K )
– i does not revise its beliefs about any other outcome of the
game
Equilibrium Outcomes: Actions
• Bilateral Efficiency
– A set of actions satisfied bilateral efficiency if for all ij in
K,
qˆij ( K ) arg max xij (qiA qiB , qˆ iA ( K ) qˆ iB ( K )) c(q1 j qˆ2 j ( K ))
• By the envelope theorem on q2B, this involves a bilaterally efficient choice of q2A.
Equilibrium Outcomes: Payoffs
• Result: As σ approaches 1, there exists a perfect
Bayesian outcome where agents receive:
vD1 1
6 3 ˆ (1A,1B, 2 A, 2 B) cˆ(1A,1B, 2 A, 2 B) 2ˆ (1 j, 2 j ) cˆ(1 j, 2 j ) ˆ (iA, iB) 2cˆ(iA, iB)
vUA 1
6 3 ˆ (1A,1B, 2 A, 2 B) cˆ(1A,1B, 2 A, 2 B) 2ˆ (1 j, 2 j ) cˆ(1 j, 2 j ) ˆ (iA, iB) 2cˆ(iA, iB)
1 1 vˆ(T , LP )
i ( N , L) (1) p 1
( p 1)!
N iT P ( p 1)( N T )
PP N T P
T T
where:
• N is the set of agents
• P is a partition over the set of agents with cardinality p
• PN is the set of all partitions of N
• L is the initial network (i.e., initial set of bilateral links)
• LP is the initial network with links severed between partitions
defined by P.
Additional Results
• (No component externalities) Suppose that primitive
payoffs are independent of actions taken by agents
not linked the agent
– Obtain the Myerson value over a bilaterally efficient
surplus.
• (No non-pecuniary externalities) Suppose that the
primitive payoffs are independent of the actions the
agent cannot observe
– Obtain the Myerson value.
• If agreements are non-binding and subject to
renegotiation, the results hold.
Computability
s
(1) s i
m buyers m
vS1
m x
i
vˆ(m s, 2)
s 0 s
i 0 m i 2
m x h i 1 m s h
( 2)
m ms m
m s ms h i (1) m s h
vˆ s | h
s 0 h 0 s h i 0 mi 2 m h 1
UA UB
D1 D2
Model Structure & Notation
• 2 upstream & 2 downstream assets each with an associated
manager (necessary for the asset to be productive); integration
changes ownership but not need to use manager at same level
• Uj can produce input quantities, q1j & q2j to D1 and D2 at cost,
cj(q1j, q2j); quasi-convex
• D1 earns (gross) profits of π1(q1A,q1B;q2A,q2B); concave in
(q1A,q1B) and non-increasing in (q2A,q2B).
• Industry profit outcomes:
UA UB UA UB
D1 D2 D1 D2
Upstream Merger
UA UB
UA
D1 D2 D1 D2
Impact on Efficiency
• Bilateral negotiations for upstream supply under
upstream competition
max q1 A 1 (q1 A , q1B ; q2 A , q2 B ) c A (q1 A , q2 A )
Upstream Upstream
Competition Monopoly
Output 2/3 2/3
Total Profits 2/9 2/9
Di payoff 0.051 0.0324
Uj payoff 0.0601 0.1574
Incentives to Merge
• Upstream firms jointly gain:
– One third of the profits from a UB Monopoly
– Intuition: the possibility that a breakdown could
generate this was used by downstream firms as
leverage on the other upstream firm
• Downstream firms jointly lose this
– Face higher transfers
Upstream Competition
• Changes to upstream competition have a different
impact to changes in downstream competition
• Fragmentation amongst downstream firms drives
impact on consumers, input and output choices. It
constrains upstream market power.
• Extreme: permit upstream mergers when there is no
vertical integration
– Leads to additional upstream investment (maybe over-
investment)
– May lead to reduced downstream entry
Vertical Integration
D1 D2
D1 D2 UA UB
FI
D1 D2
Will D1 and UA profit from VI?
UC UM
1 ˆ (D D U U )
UC ˆ (D D U U )
2 1 2 A B 1
2UM 1 2 A B
1 ˆ (D D U )
FI 6 UC 1 2 A 1 ˆ (D D U )
UM 1 2 A
6
ˆ ( D D U ) ( D U )
16 1 2 B 2 B
1 ˆ (D D U U )
UC 1 ˆ (D D U U )
UM
2 1 2 A B 2 1 2 A B
1 ˆ (D D U ) 1 ˆ (D D U )
BI 6 UC 1 2 A 6 UM 1 2 A
16 ( D1U AU B ) ( D2U B ) ˆ (D D U )
16 ( D2U AU B ) 1 2 B
Comparisons
• FI versus BI
ˆ ( D D U ) ( D U U )
1 2 B 2 A B
• UC versus UM
1
3 ˆ ( D D U
1 2 B ) ( D2U B )
ˆˆ ˆˆ
UM ( D1 D2U AU B ) UC ( D1 D2U AU B )
vD2 ( FI ) 121 ( D1 D2U AU B ) ( DU
i j)
Technical foreclosure but downstream firm still
valuable in disciplining internal negotiations
Quantitative Evaluation
max qij P(Q) qij k j qik ci (qij ,.) Ci (.) P(Q) k q jk c j (.) C j (qij ,.)
P(Q) k (qik q jk )
ci C j
P 1
si s j
qij qij
P P
Vertical HHI
• The average Lerner index is:
N N
1
s ( si i qii / Q) HHI
i 1 i
1
1
s ( i qii / Q)
i 1 i
HHI s
N 2
i 1 i
N
VHHI 1
s max{si , i }
i 1 i
Properties
• Ranges between 0 (perfect competition) and 10,000
(downstream monopoly)
– Collapses to HHI (Downstream) when all downstream
firms are net buyers of inputs or non-integrated
– If there is integration then VHHI > HHI
• Upstream concentration not relevant
– Non-integrated upstream mergers do not change VHHI
– Only look upstream if merger involves a net supplier
Some Examples
• Example 1:
– 4 equal sized upstream firms and 10 equal sized
downstream ones
– Up HHI = 2500; Down-HHI = 1000 = VHHI
– Vertical merger leaves HHI’s unchanged (no concern) but
raises VHHI to 1150 (potential concern)
• Example 2:
– 8 downstream firms with 10% share and a 9th with 20%
share
– If vertical merger involves large firm then HHI does not
change but VHHI goes from 1300 to 1400 (no concern)
despite higher concentration.
Approach #2: Successive Oligopoly
• Firm’s post unit prices in wholesale market
• With linear demand and costs (and
homogenous inputs):
N N N N 2
s ( j s j )
( si min[ si , i ])( j min[ s j , j ])
VHHI 1
max[ s j , j ] 1
j 1
j
j 1
j
j 1 i 1
1 i min[ si , i ]