Industrial Organization
Strategic Vertical Integration (Chap. 10)
Philippe Choné, Philippe Février, Laurent Linnemer and
Thibaud Vergé
CREST-LEI
2009/10
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Introduction
Vertical integration and antitrust
Chicago-like (laissez faire) opinion
Elimination of the double marginalization
No effect on downstream competition
Vertical merger does not create or increase the firm’s
power to restrict output. The ability to restrict output
depends on the share of the market occupied by the
firm. Horizontal mergers increase market share, but
vertical mergers do not.
Robert Bork, 1978
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Vertical integration and antitrust
Some reservations
Typical antitrust concerns
Market foreclosure (input)
Strategic vertical integration (raising rival’s cost)
Collusion issues
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Raising Rival Cost Theory
Kratenmaker and Salop, 1986
Step by step
1
Buy a supplier (resp. a retailer)
2
Withdraw from the input market
3
Input market becomes less competitive, price%
4
Downstream: Competitors’ prices%
5
Integrated firm: price% and profit%
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When is RRC a real issue?
6 criticisms
Criticisms 1 to 3
1. Competition might be unaffected upstream
Downstream market share 10% buys a producer with 10%
input market share
2. Why is it profitable to withdraw from the input market?
The integrated firm can undercut other input suppliers
3. Input price could be unaffected by the merger
Enough competition after the merger
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When is RRC a real issue?
6 criticisms
Criticisms 4 to 6
4. Counterattack: vertical integration
5. Is vertical integration profitable in the first place?
The supplier asks for too high a price
6. Is vertical integration profitable in the first place?
Competitive bidding to buy the supplier
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Outline
1
Ordover, Saloner and Salop, AER 1990
2
Chen, RAND 2001
3
Linnemer, JEMS 2003
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Ordover, Saloner and Salop AER 1990
Equilibrium vertical forclosure
U1
w1
U2
w2
Before integration
Bertrand Competion Upstream
⇒ w1 = w2 = 0
D1
D2
p1
p2
Consommateurs
Downstream, symmetric
equilibrium p1∗ = p2∗
p1∗ (c1 , c2 ) and p2∗ (c1 , c2 )
Π∗1 (c1 , c2 ) and Π∗2 (c1 , c2 )
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Ordover, Saloner and Salop AER 1990
Equilibrium vertical forclosure
U1
U2
w2
0
w1
U1-D1 integrated but U1 sells to D2
If competition remains à la
Bertrand between U1 and U2
D1
D2
p1
p2
Then w1∗ = w2∗ = 0
No strategic effect of vertical
integration
Consommateurs
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Ordover, Saloner and Salop AER 1990
Equilibrium vertical forclosure
U1
0
U2
w2 = w m
D1
D2
p1
p2
Consommateurs
U1-D1 integrated not competing
upstream
U2 is a monopoly
Everything looks fine for U1-D1
(and U2)
c1 = 0, c2 = w m
However D2 could try to
counter-integrate, buying U2
Π∗1 (0, w m ) > Π∗i (0, 0) > Π∗2 (0, w m )
Is the integration U2-D2
profitable?
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Ordover, Saloner and Salop AER 1990
Equilibrium vertical forclosure
U1
0
U2
w2 = 0
D1
D2
p1
p2
Consommateurs
Integration U2-D2
Condition:
π m + Π2 (0, w m ) < 0 + Π2 (0, 0)
Due to the elimination of the
double marginalization U2-D2 are
better off integrated (intuition and
proof!)
The integration U1-D1 has been
useless strategically
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Ordover, Saloner and Salop AER 1990
Equilibrium vertical forclosure
U1
U2
0
w
w
D1
p1
Other options for U1?
Too much competition upstream⇒
vertical integration U1-D1
worthless
+
D2
p2 (w)
Too little competition upstream⇒
vertical integration U1-D1
worthless
Middle ground?
Consommateurs
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Ordover, Saloner and Salop AER 1990
Equilibrium vertical forclosure
U1
U2
0
w
w+
D1
p1
D2
p2 (w)
Integration + choice of w
U1 commits to sell for w + but not
for a lower price (as w + < w m
antitrust friendly)
Characterization of the equilibrium
First, w2 = w
Consommateurs
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Ordover, Saloner and Salop AER 1990
Equilibrium vertical forclosure
Choice of w by U1-D1
∗
max πU1+D1
(w) = 0 + Π1 (0, w)
w
subject to
Π∗U2 (w) + Π∗2 (0, w) ≥ Π∗2 (0, 0)
Π∗U2 (w) + Π∗2 (0, w) ≥
|
{z
}
Profits if separated
Π∗ (0, 0)
| 2 {z }
Profits if integrated
Binding constraint
Π∗U2 (w) + Π∗2 (0, w) = Π∗2 (0, 0)
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Ordover, Saloner and Salop AER 1990
Equilibrium vertical forclosure
Does w exist?
∃w > 0 such that
Π∗U2 (w) + Π∗2 (0, w) > Π∗2 (0, 0)
It is enough to check at w = 0+
Proof
dΠ∗2
dΠ∗U2 (w)
dD ∗
= D2 (p1∗ , p2∗ ) + w 2
dw
dw
p1∗ , p2∗ , w
∂p1∗ ∂Π∗2
=
+ 0 − D2 (p1∗ , p2∗ )
dw
∂w ∂p1
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Ordover, Saloner and Salop AER 1990
Equilibrium vertical forclosure
Bidding Process to buy U1
D1 wins Π∗1 (0, w) thanks to integration
If D2 wins the auction, D1 is left with Π∗1 (w, 0)
D1 has to bid
Π∗1 (0, w) − Π∗1 (w, 0)
In any case D1 profit is: Π∗1 (w, 0)
That is, less than before integration : Π∗1 (0, 0)
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Ordover, Saloner and Salop AER 1990
Equilibrium vertical forclosure
To sum up
D1 and D2 play a prisoner dilemma game
Vertical Integration is both agressive and defensive
Winners are U1 and U2
Consumers lose as prices % (i.e. S &)
W & (no efficiency gains)
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Reiffen AER 1992
3 criticisms of OSS
Model Tricks
1
No problem if there is a third supplier
2
The possibility to fix w > 0 is a hidden commitment
3
If D1 can commit, then prices% without vertical integration
Unless some causal nexus between vertical
integration and the ability to commit to a pricing
strategy is demonstrated, it is difficult to see how the
OSS results are related to vertical integration at all.
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Ordover, Saloner and Salop AER 1990
Reply to criticisms
The results in OSS do not depend on the ability to
commit. Instead, our main result stems from the fact
that vertical integration changes the firm’s incentives
to engage in price-cutting in the input market. The
notion that vertically integrated firms behave differently
from unintegrated ones in supplying inputs to
downstream rivals would strike a businessperson, if
not an economist, as common sense. We show that
there is theoretical merit to that common-sense view.
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Chen, RAND 2001
Another tradeoff: the opposite of foreclosure
Initial configuration
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Chen, RAND 2001
Another tradeoff: the opposite of foreclosure
Vertical integration
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Chen, RAND 2001
Another tradeoff: the opposite of foreclosure
Effects on consumers prices?
p1 & as the input price&
p2 should also & (competition in D)
But Is U1-D1 able to increase w1 above c?
YES! D2 agrees to buy from U1-D1 at w1 > c
⇒collusion-like effect
But efficiency-like effect as p1 &
Or pass through effect
Overall Prices can go down or up
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Chen, RAND 2001
Another tradeoff: the opposite of foreclosure
Element of proof
Profit of I=U1-D1 when selling to D2 (w1 fixed):
π1I = p1 q1 (p1 , p2 ) + w1 q2 (p1 , p2 )
Denote piI (w1 ) equilibrium price if D2 buys from U1-D1
Denote pi (w2 ) equilibrium price if D2 buys from U2
Key result piI (w1 ) > pi (w1 ) when w1 > 0
(note that the input price is the same)
⇒ π2I (w1 ) > π2 (w1 ) when w1 > 0
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Chen, RAND 2001
Idea of the proof
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Linnemer, JEMS 2003
Backward integration by a dominant firm
Initial Set-up (heterogeneous firms downstream)
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Linnemer, JEMS 2003
Backward integration by a dominant firm
The identity of the merging firm is important
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Linnemer, JEMS 2003
Backward integration by a dominant firm
Paradoxical result
Assume no efficiency gains: ε = 0
Assume an input price increase w > 0
⇒ price% (e.g. Cournot)
Consumers lose
⇒ if si∗ is large enough
W %
Efficient reallocation of the production
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