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1 1 / 30 Industrial Organization Strategic Vertical Integration (Chap. 10) Philippe Choné, Philippe Février, Laurent Linnemer and Thibaud Vergé CREST-LEI 2009/10
2 2 / 30 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
3 3 / 30 Vertical integration and antitrust Some reservations Typical antitrust concerns Market foreclosure (input) Strategic vertical integration (raising rival s cost) Collusion issues
4 4 / 30 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
5 5 / 30 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
6 6 / 30 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
7 7 / 30 Outline 1 Ordover, Saloner and Salop, AER Chen, RAND Linnemer, JEMS 2003
8 9 / 30 Ordover, Saloner and Salop AER 1990 Equilibrium vertical forclosure U 1 U 2 Before integration w 1 w 2 D 1 D 2 p 1 p 2 Consommateurs Bertrand Competion Upstream w 1 = w 2 = 0 Downstream, symmetric equilibrium p 1 = p 2 p 1 (c 1, c 2 ) and p 2 (c 1, c 2 ) Π 1 (c 1, c 2 ) and Π 2 (c 1, c 2 )
9 10 / 30 Ordover, Saloner and Salop AER 1990 Equilibrium vertical forclosure U 1 U 2 0 w 2 w 1 D 1 D 2 p 1 p 2 U1-D1 integrated but U1 sells to D2 If competition remains à la Bertrand between U1 and U2 Then w 1 = w 2 = 0 No strategic effect of vertical integration Consommateurs
10 Ordover, Saloner and Salop AER 1990 Equilibrium vertical forclosure U 1 U 2 0 w 2 = w m D 1 D 2 p 1 p 2 Consommateurs U1-D1 integrated not competing upstream U2 is a monopoly Everything looks fine for U1-D1 (and U2) c 1 = 0, c 2 = 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? 11 / 30
11 Ordover, Saloner and Salop AER 1990 Equilibrium vertical forclosure U 1 U 2 0 w 2 = 0 D 1 D 2 p 1 p 2 Consommateurs Integration U2-D2 Condition: π m + Π 2 (0, w m ) < 0 + Π 2 (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 12 / 30
12 13 / 30 Ordover, Saloner and Salop AER 1990 Equilibrium vertical forclosure U 1 U 2 0 w w + D 1 D 2 p 1 p 2 (w) Consommateurs Other options for U1? Too much competition upstream vertical integration U1-D1 worthless Too little competition upstream vertical integration U1-D1 worthless Middle ground?
13 14 / 30 Ordover, Saloner and Salop AER 1990 Equilibrium vertical forclosure U 1 U 2 0 w w + D 1 D 2 p 1 p 2 (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, w 2 = w Consommateurs
14 Ordover, Saloner and Salop AER 1990 Equilibrium vertical forclosure Choice of w by U1-D1 subject to max w π U1+D1 (w) = 0 + Π 1 (0, w) Π U2 (w) + Π 2 (0, w) Π 2 (0, 0) Π U2 (w) + Π 2 (0, w) }{{} Profits if separated Π 2 (0, 0) }{{} Profits if integrated Binding constraint Π U2 (w) + Π 2 (0, w) = Π 2 (0, 0) 15 / 30
15 Ordover, Saloner and Salop AER 1990 Equilibrium vertical forclosure Does w exist? w > 0 such that It is enough to check at w = 0 + Π U2 (w) + Π 2 (0, w) > Π 2 (0, 0) Proof dπ 2 dπ U2 (w) dw ( p 1, p2, w) dw = D 2 (p 1, p 2 ) + w dd 2 dw = p 1 w Π 2 p D 2 (p 1, p 2 ) 16 / 30
16 17 / 30 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)
17 18 / 30 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)
18 19 / 30 Reiffen AER 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.
19 20 / 30 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.
20 22 / 30 Chen, RAND 2001 Another tradeoff: the opposite of foreclosure Initial configuration
21 23 / 30 Chen, RAND 2001 Another tradeoff: the opposite of foreclosure Vertical integration
22 24 / 30 Chen, RAND 2001 Another tradeoff: the opposite of foreclosure Effects on consumers prices? p 1 as the input price p 2 should also (competition in D) But Is U1-D1 able to increase w 1 above c? YES! D2 agrees to buy from U1-D1 at w 1 > c collusion-like effect But efficiency-like effect as p 1 Or pass through effect Overall Prices can go down or up
23 25 / 30 Chen, RAND 2001 Another tradeoff: the opposite of foreclosure Element of proof Profit of I=U1-D1 when selling to D2 (w 1 fixed): π I 1 = p 1q 1 (p 1, p 2 ) + w 1 q 2 (p 1, p 2 ) Denote p I i (w 1) equilibrium price if D2 buys from U1-D1 Denote p i (w 2 ) equilibrium price if D2 buys from U2 Key result p I i (w 1) > p i (w 1 ) when w 1 > 0 (note that the input price is the same) π I 2 (w 1) > π 2 (w 1 ) when w 1 > 0
24 Chen, RAND 2001 Idea of the proof 26 / 30
25 28 / 30 Linnemer, JEMS 2003 Backward integration by a dominant firm Initial Set-up (heterogeneous firms downstream)
26 29 / 30 Linnemer, JEMS 2003 Backward integration by a dominant firm The identity of the merging firm is important
27 30 / 30 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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