Vertical mergers Double marginalization Foreclosure Empirical evidence
Vertical mergers
Industrial organization – lecture 5
Vertical mergers Double marginalization Foreclosure Empirical evidence
Vertical mergers
Pepall et al. (2014, pp. 427–428)
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.
Each firm’s pricing decision imposes an externality on the other firm:
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. (2014, pp. 428–432)
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
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
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 and price are Q∗
= A−c
4B and P∗
= 3A+c
4 .
Vertical mergers Double marginalization Foreclosure Empirical evidence
Double marginalization: Solution
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. (2014, pp. 435-436, 441–446)
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
Vertical mergers Double marginalization Foreclosure Empirical evidence
OSS model: experiment – nonintegration
The experiment simulates the choice of upstream firms (step 2).
The timing:
1. Choose price individually from p ∈ [1, 2, . . . , 9]
2. Determine market price pM = min{p1
, p2
}
3. Calculate profit
π1
=



Bertrand profit(pM ) if p1
= pM < p2
1
2
× Bertrand profit(pM ) if p1
= pM = p2
0 if p1
> pM
Vertical mergers Double marginalization Foreclosure Empirical evidence
OSS model: experiment – integration
Timing:
1. Choose price individually from p ∈ [1, 2, . . . , 9]
2. Determine market price pM = min{pNI
, pI
}
3. Calculate profit:
• The nonintegrated firm (NI) as before.
• The profit integrated firm (I):
πI
=



Bertrand profit(pM ) + Additional profit(pM ) if pI
= pM < pNI
1
2
× Bertrand profit(pM ) + Additional profit(pM ) if pI
= pM = pNI
Additional profit(pM ) if pI
> pM
Vertical mergers Double marginalization Foreclosure Empirical evidence
Foreclosure: GE-Honeywell merger
Pepall et al. (2010, pp. 446-447)
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. (2014, pp. 453-455)
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
Main results:
How do you interpret this?