Vertical mergers Double marginalization Foreclosure Empirical evidence
Vertical mergers
Industrial organization – lecture 5
Vertical mergers Double marginalization Foreclosure Empirical evidence
Vertical mergers
Vertical mergers join firms operating at different levels of production
chain (e.g. producer and retailer).
What are the effects of a vertical merger compared to a horizonal merger?
Vertical mergers join firms producing complementary products.
Internalization of this externality is Pareto improving.
Case:
In 2000 GE and Honeywell announced merger. GE produces jet engines,
Honeywell produces starter motors and other inputs for aircraft engines.
In July 2001 the merger was blocked by EC. Why?
Vertical mergers Double marginalization Foreclosure Empirical evidence
Double marginalization
Pepall et al. (2010, pp. 325–328)
What are the pro-competitive effects of vertical mergers?
• Each firm in a production chain provides an essential input to other
firms in the chain.
• Firms on each level of the production chain have some market power.
• Firms on each level of the production chain charges some mark-up
above marginal costs.
• The price for final consumers may be higher than the monopoly
price.
• This problem is called double marginalization.
Vertical mergers Double marginalization Foreclosure Empirical evidence
Double marginalization: Model
Pepall et al. (2010, pp. 325–328)
There is a single manufacturer m and single retailer r.
The producer produces the good at a constant unit cost c
and sells it to the retailer at a wholesale price w.
The retailer resells the product to the final consumer at a final price P.
The inverse demand function is linear P = A − BQ.
Vertical mergers Double marginalization Foreclosure Empirical evidence
Double marginalization: Solution
Pepall et al. (2010, p. 301-304)
Solution of the model is given by backward induction.
Profit maximizing price and output of the retailer for given wholesale
price w are Q(w) = A−w
2B and P(w) = A+w
2
Substituting the retailer’s output into the profit function of the
manufacturer and maximizing with respect to w gives the optimal
wholesale price w∗
= A+c
2 .
The retailer’s equilibrium output is thus Q∗
= A−c
4B
Vertical mergers Double marginalization Foreclosure Empirical evidence
Double marginalization: Solution
Pepall et al. (2010, p. 301-304)
After merger the whole industry is monopolized.
The profit maximizing output and price of the integrated firm are
QI
= A−c
2B and PI
= A+c
2 .
The merger results in a lower price, a greater quantity, higher profits,
and a higher consumer surplus.
Two assumptions are crucial for this analysis
1. Fixed proportion between inputs and outputs
2. Linear pricing
Vertical mergers Double marginalization Foreclosure Empirical evidence
Foreclosure
Pepall et al. (2010, p. 332-333)
There can be also anti-competitive effects of vertical mergers.
The most important one is foreclosure. The integrated company may
choose to deny a downstream competitor a source of inputs.
Consider an industry with two independent manufacturers and two
independent retailers.
• Is vertical integration profitable? Yes
• Can vertical integration harm the consumers? Yes
We illustrate the foreclosure logic in the model by Ordover, Saloner and
Salop (1990).
Vertical mergers Double marginalization Foreclosure Empirical evidence
OSS model
Pepall et al. (2010, p. 338-342)
There are two manufacturer mi and two retailers ri . Prices are, again,
denoted as pi and wi .
The retailers’ demands are qr
i = 1 − pi + βpj where parameter β ∈ (0, 1)
measures the degree of product differentiation.
Marginal cost are normalized to zero.
We solve the model in three versions:
1. Without merger
2. With merger and foreclosure
3. With merger and without foreclosure
Vertical mergers Double marginalization Foreclosure Empirical evidence
OSS model: Retailer’s subgame
Pepall et al. (2010, p. 338-342)
Profit of retailer i given it pays wholesale price wi is
Πr
i = (pi − wi )(1 − pi + βpj ).
We derive best-responses and solve for retailers’ prices.
The equilibrium price is p∗
i (wi , wj ) =
2+β+2wi +βwj
4−β2 and the equilibrium
quantity is q∗
i (wi , wj ) =
2+β−(2−β2
)wi +βwj
4−β2
You can check that the equilibrium profit is Πi = (q∗
i (wi , wj ))2
Vertical mergers Double marginalization Foreclosure Empirical evidence
OSS model: Manufacturer’s subgame
Pepall et al. (2010, p. 338-342)
Version 1: Manufacturers charges w1 = w2 = 0 because of Bertrand
competition.
Version 2: Marginal cost of integrated firm is zero. Manufacturer 2
charges w2 = 2+β
2(2−β2) .
Version 3: Manufacturers again behaves like Bertrand competitors
resulting in w1 = w2 = 0.
Conclusion: The final prices increase if and only if the integrated firm
can credibly commit to not deliver to competing retailer. If such a
commitment is available integration raises rival’s cost and final prices.
However, existence of such a commitment is unlikely.
Vertical mergers Double marginalization Foreclosure Empirical evidence
Foreclosure: GE-Honeywell merger
Pepall et al. (2010, p. 343-344)
It is a pretty famous and a very controversial case.
Citation of commission’s report (par. 355):
Because of their lack of ability to match the bundle offer ... independent
suppliers will lose market shares to the benefit of the merged entity and
experience an immediate damaging of profit shrinkage. As a result, the
merger is likely to lead to market foreclosure ... and to the elimination of
competition in these areas.
Does it make sense?
Vertical mergers Double marginalization Foreclosure Empirical evidence
Empirical evidence: Concrete industry
Pepall et al. (2010, p. 346-348)
Hortacsu, Syverson (2007, JPE) study the effect of vertical integration on
prices.
Why concrete industry?
• Fixed proportion between input and output
• Variation in vertical integration
• High transportation cost creates many local markets. Many markets
mean many independent observations.
Estimated equation Pit = α + βVIit + γXit, where
Pit is the average concrete price,
VIit is the share of vertically integrated firms,
Xit are control variables (market and year fixed effects, HHI, ...)
Vertical mergers Double marginalization Foreclosure Empirical evidence
Empirical evidence: Concrete industry
Pepall et al. (2010, p. 346-348)
Main results:
Variable
Market share of VI firms −0.09∗
−0.086∗
−0.043
Market share of multiple plant firms - −0.15 −0.001
Total factor productivity - - −0.293∗
R2
0.433 0.434 0.573
How do you interpret this?