EC 171: Topics in Industrial Organization

EC 171: Topics in Industrial Organization
Section 2: Mergers EC 171: Topics in Industrial Organization

Introduction Merger mania is everywhere each week brings new announcements of mega-mergers AOL/Time-Warner Pfizer/Warner-Lambert Vodafone/Mannesman each year seems to break the record of the year before Reasons for merger are many need to become “global” response to other mergers search for synergies in operations to achieve significant cost savings EC 171: Topics in Industrial Organization

Questions Why do mergers occur? many reasons have been suggested relating to costs and market power Are mergers beneficial or is there a need for regulation? the US government is particularly concerned with these questions anti-trust website mergers might not be beneficial: they operate like legal cartels Are all mergers the same or are there different types? distinguish mergers that are horizontal complementary vertical EC 171: Topics in Industrial Organization

Horizontal mergers Merger between firms that compete in the same product market some bank mergers hospitals oil companies Begin with a surprising result: the merger paradox take the standard Cournot model merger that is not merger to monopoly is unlikely to be profitable unless “sufficiently many” of the firms merge with linear demand and costs, at least 80% of the firms but this type of merger is unlikely to be allowed EC 171: Topics in Industrial Organization

This merger is unprofitable and should not occur
An Example  Assume 3 identical firms; market demand P = Q; each firm with marginal costs of $20. The firms act as Cournot competitors.  Applying the Cournot equations we know that: each firm produces output q(3) = ( )/(3 + 1) = 30 units the product price is P(3) = x30 = $50 profit of each firm is p(3) = ( )x30 = $900  Now suppose that two of these firms merge then there are two independent firms so output of each changes to: q(2) = ( )/3 = 40 units; price is P(2) = x40 = $60 profit of each firm is p(2) = ( )x40 = $1,600  But prior to the merger the two firms had aggregate profit of $1,800 This merger is unprofitable and should not occur EC 171: Topics in Industrial Organization

Merger to monopoly is always profitable
Example (cont.)  Now suppose that all three firms merge.  This creates a monopoly so that we have: output = ( )/2 = 60 units price = ( ) = $80 profit = p(1) = ( )x60 = $3,600  Prior to this merger aggregate profit was 3x$900 = $2,700 Merger to monopoly is always profitable EC 171: Topics in Industrial Organization

A Generalization  Take a Cournot market with N identical firms.
 Suppose that market demand is P = A - B.Q and that marginal costs of each firm are c.  From standard Cournot analysis we know that the profit of each firm is: (A - c)2 The ordering of the firms does not matter pCi = B(N + 1)2  Now suppose that firms 1, 2,… M merge. This gives a market in which there are now N - M + 1 independent firms. EC 171: Topics in Industrial Organization

Generalization (cont.)
 The newly merged firm chooses output qm to maximize profit, given by pm(qm, Q-m) = qm(A - B(qm + Q-m) - c) where Q-m = qm+1 + qm+2 + …. + qN is the aggregate output of the N - M firms that have not merged  Each non-merged firm chooses output qi to maximize profit: pi(qi, Q-i) = qi(A - B(qi + Q-i) - c) where Q-i = is the aggregate output of the N - M firms excluding firm i plus the output of the merged firm qm  Comparing the profit equations then tells us: the merged firm becomes just like any other firm in the market all of the N - M + 1 post-merger firms are identical and so must produce the same output and make the same profits EC 171: Topics in Industrial Organization

Generalization (cont.)
 The profit of each of the merged and non-merged firms is then: Profit of each surviving firm increases with M (A - c)2 pCm = pCnm = B(N - M + 2)2  The aggregate profit of the merging firms pre-merger is: M.(A - c)2 M.pCi = B(N + 1)2  So for the merger to be profitable we need: (A - c)2 M.(A - c)2 > this simplifies to: B(N - M + 2)2 B(N + 1)2 (N + 1)2 > M(N - M + 2)2 M > 0.8N for this inequality to be satisfied EC 171: Topics in Industrial Organization

The Merger Paradox Why is this happening? the merged firm cannot commit to its potentially greater size the merged firm is just like any other firm in the market thus the merger causes the merged firm to lose market share the merger effectively closes down part of the merged firm’s operations this appears somewhat unreasonable Can this be resolved? need to alter the model somehow product differentiation Bertrand competition give the merged firms some additional market power perhaps they can exercise market leadership EC 171: Topics in Industrial Organization

Horizontal Merger and Leadership
Suppose that when two firms merge they become Stackelberg leaders how does this affect merger profitability? what is the impact on consumers? EC 171: Topics in Industrial Organization

Merger and leadership: an example
 Suppose that there are N identical Cournot firms in the market  Market demand is P = Q and marginal cost is $20  Prior to the merger the Cournot equilibrium has: output of each firm: 120/(N + 1); price: PC = ( N)/(N + 1) profit of each firm: pC = 14,400/(N + 1)2  Now suppose that 2 firms merge and become market leaders  Since a merger is a legal cartel we can use the Selten analysis of the previous chapter to get the effect of this merger  The merged firm will produce the Stackelberg output: QL = ( )/2 = 60 units EC 171: Topics in Industrial Organization

The leadership example (cont.)
 There are N - 2 non-merged firms that act as followers. So they each produce output: 60 qF = = 2(N - 1) (N - 1) 60(N - 2) 60(2N - 3)  Total output is: QT = 60 + = (N - 1) (N - 1) N  Price is: PL = QT = (N - 1) 60 and the price-cost margin is PL - 20 = (N - 1) EC 171: Topics in Industrial Organization

 Profit of the merged (lead) firm is: pL = (PL - 20)QL = 3,600/(N - 1)  Profit of each non-merged (follower) firm is: pF = (PL - 20)qF = 3,600/(N - 1)2 The merged firm is always more profitable than each non-merged firm  Is the merger profitable for the merged firms? Profit pre-merger was: 2pC = 28,800/(N + 1)2 3,600 28,800 so pL > 2pC requires: > which requires: (N - 1) (N + 1)2 (N + 1)2 > 8(N - 1) This is always true for N > 3 EC 171: Topics in Industrial Organization

 What about the effect of the merger on the non-merged firms and on consumers?  Profit pre-merger was: pC = 14,400/(N + 1)2 3,600 14,400 so pF > pC requires: > which requires: (N - 1)2 (N + 1)2 (N + 1)2 > 4(N - 1)2 This is only true for N < 3  The pre-merger price-cost margin is: PC - 20 = 120/(N + 1)  The post-merger price-cost margin is: PL - 20 = 60/(N - 1) 60 120 the merger reduces price if: < or 60N + 60 > 120N - 120 N - 1 N + 1 This is true if N > 3 EC 171: Topics in Industrial Organization

Mergers and Market Leadership
A two-firm merger that creates a market leader is profitable for the merged firms if there are three or more firms in the market Moreover, such a merger increases the market share of the merged firms reduces profit and market share for each non-merged firm benefits consumers by reducing price So why worry about mergers? What might the non-merged firms do? Will they also seek merger partners? If so, what then happens to price and consumer welfare? EC 171: Topics in Industrial Organization

Mergers and leadership (cont.)
The “leadership” merger reduces profits of the non-merged firms Won’t these firms also seek merger partners? certainly consistent with casual evidence So, consider more than one two-firm merger creates a series of merged firms and a series of non-merged firms How does “leadership” work here? (Daughety) merged firms compete against each other but as a group act as leaders relative to the non-merged firms another variant on the Cournot model EC 171: Topics in Industrial Organization

Need to distinguish output decisions of the group of leaders (L) and the group of followers (F) stage game stage 1: leaders each choose their output levels in competition with the other lead firms stage 2: followers see output decisions of the lead firms then choose their outputs with respect to residual demand in competition with other follower (non-merged) firms Stick with the Cournot model we have used market demand P = Q; marginal cost $20; N firms the firms are in two groups L leaders or merged firms N - L followers or non-merged firms solve this game “backwards” EC 171: Topics in Industrial Organization

 Suppose that the aggregate output of the lead firms is QL  Residual demand for the non-merged firms is then: P = QL - QF where Q = QL + QF and QF is output of the non-merged firms  QF can be written qf + QF-f where QF-f denotes output of the non-merged firms other than firm f  So the profit of non-merged firm f can be written: pf = (140 - QL - QF-f - qf - 20)qf = (120 - QL - QF-f - qf)qf  Differentiate this with respect to qf to give the condition: pf/ qf = 120 - QL - QF-f - 2qf = 0 Solve this for qf EC 171: Topics in Industrial Organization

An example of leadership (cont.)
 We have the best response function for firm f: qf = 60 - QL/2 - QF-f/2 as a response to both the output of the leaders and the other followers  But all the followers are identical so in equilibrium they produce the same outputs: so Q*F-f = (N - L - 1)q*f so q*f = 60 - QL/2 - (N - L - 1)q*f/2 so (N - L + 1)q*f/2 = 60 - QL/2 120 - QL q*f = N - L + 1  Aggregate output of the non-merged firms is then: (N - L)(120 - QL) Q*F = N - L + 1 EC 171: Topics in Industrial Organization

 What about a lead (merged) firm in stage 1?  The same technique can be used. Residual demand for a lead firm is: P = QF - QL = 140 - QF - Q-l - ql where Q-l is output of all the lead firms other than firm l  The difference between the merged firms and the non-merged firms is that each merged firm knows what QF is going to be.  The typical lead firm correctly anticipates the actions of the non-merged firms and so can use this information Q*F = (N - L)(120 - QL) N - L + 1  Recall that and substitute this into the residual demand equation EC 171: Topics in Industrial Organization

 This gives the residual demand equation For the moment we treat the merged firms as a group (N - L)(120 - QL) P = 140 - - QL N - L + 1 (N - L) (N - L)QL = + - QL N - L + 1 N - L + 1 (N - L) QL = - N - L + 1 N - L + 1  This can now be rewritten: (N - L) - Q-l ql P = - N - L + 1 N - L + 1 EC 171: Topics in Industrial Organization

 Profit of a typical merged firm is: pl = (P - 20)ql  But we know what P is so we have (N - L) - Q-l ql P - 20 = - - 20 N - L + 1 N - L + 1 Q-l ql = - N - L + 1 N - L + 1  So profit of a typical merged firm becomes: (120 - Q-l - ql) pl = ql (N - L + 1)  Differentiate this with respect to ql to give the profit maximizing condition. EC 171: Topics in Industrial Organization

(120 - Q-l - ql) (N - L + 1) ql  We have:  Differentiating gives the condition: 120 - Q-l - 2ql pl/ ql = = 0 N - L + 1  So we have the condition: Q*-l + 2q*l = 120  In solving this we can again use a symmetry argument: Since Q-l contains L - 1 firms in equilibrium all the lead firms will have the same output so Q*-l = (L - 1)q*l which gives: (L + 1)q*l = 120 so q*l = 120/(L + 1)  Aggregate output of the merged firms is then: Q*L = 120L/(L + 1) EC 171: Topics in Industrial Organization

Q*F = (N - L)(120 - QL) N - L + 1  Recall that Now substitute for Q*L = 120L/(L + 1). This gives: Q*F = (N - L)120 (N - L + 1)(L + 1) q*F = 120 (N - L + 1)(L + 1) and This has been a lot of work!!! But now we can see the effect of a group of mergers. We can easily compare outputs of the different types of firms. The leader (merged) firms are larger than the follower (non-merged) firms: as we would expect EC 171: Topics in Industrial Organization

What about profits? Is the profit of a leader firm more than twice that of the profit it would make as a follower? To make this comparison we need the equilibrium price. Aggregate output is: Q*F + Q*L (N - L)120 120L 120(N + NL - L2) so Q*T = + = (N - L + 1)(L + 1) (L + 1) (N - L + 1)(L + 1) This looks nasty but check that it is greater than the Cournot output Stackelberg leaders produce more than Cournot firms. This reduces output of the followers but not by an offsetting amount. Followers are under pressure: lower output and lower prices. Increases the likelihood that followers will merge. EC 171: Topics in Industrial Organization

Check the profitability of an additional merger. To do so,we need profits of followers and leaders. This requires that we calculate the price-cost margin. 120(N + NL - L2) Price is PL = Q*T = 140 - (N - L + 1)(L + 1) and the price-cost margin is PL - 20 which gives: 120 PL - 20 = (N - L + 1)(L + 1) This then gives us the profit equations for each type of firm EC 171: Topics in Industrial Organization

Profit of a typical follower is: 14,400 pf(N, L) = (N - L + 1)2(L + 1)2 Profit of a typical leader is: 14,400 pl(N, L) = (N - L + 1)(L + 1)2 Each leader is more profitable than each follower but this is not the appropriate comparison Compare profits of two followers before they merge with their profits after they merge. EC 171: Topics in Industrial Organization

Starting from any configuration of leaders and followers a further two firms will always wish to merge. Is such a group of two-firm mergers desirable for consumers? firms that join the leader group increase output but there are fewer firms in the market So will a further two-firm merger increase or decrease output? for this to happen we must have L < N/3 - 1 For price to fall as a result of a merger the leader group should contain no more than one-third of the total number of firms in the market EC 171: Topics in Industrial Organization

Product Differentiation and Merger
The discussion so far has assumed that products are identical It can be extended to differentiated products: suppose demand is of the form: q1 = A - Bp1 + C(p2 + p3 +…+ pn) and similarly for the other products Now a merger allows coordination of the outputs of the different products but the merger does not lead to one of the products being eliminated EC 171: Topics in Industrial Organization

An Example of Product Differentiation
QC = PC PP MCC = $4.96 QP = PP PC MCP = $3.96 This example can be generalized to more than two products EC 171: Topics in Industrial Organization

Product differentiation
Take a different approach spatial model of product differentiation The idea is simple suppose firms are offering different varieties of a product the analogy is that these products have different “locations” then merger between some of these firms avoids some of the problems of the merger paradox don’t have to close down particular locations but can coordinate prices and, perhaps, locations Many mergers “look like” this join product lines that compete but do not perfectly overlap EC 171: Topics in Industrial Organization

The Spatial Model The model is as follows a market called Main Circle of length L consumers uniformly distributed over this market supplied by firms located along the street the firms are competitors: fixed costs F, zero marginal cost each consumer buys exactly one unit of the good provided that its full price is less than V consumers incur transport costs of t per unit distance in travelling to a firm a consumer buys from the firm offering the lowest full price What prices will the firms charge? To see what is happening consider two representative firms EC 171: Topics in Industrial Organization

The spatial model illustrated
Assume that firm 1 sets price p1 and firm 2 sets price p2 What if firm 1 raises its price? Price Price p’1 p2 p1 xm x’m Firm 1 All consumers to the left of xm buy from firm 1 xm moves to the left: some consumers switch to firm 2 Firm 2 And all consumers to the right buy from firm 2 EC 171: Topics in Industrial Organization

The Spatial Model Suppose that there are five firms evenly distributed 1  these firms will split the market r12 r51  we can then calculate the Nash equilibrium prices each firm will charge 2 5  each firm will charge a price of p* = tL/5 r45 r23  profit of each firm is then tL2/25 - F 4 3 r34 EC 171: Topics in Industrial Organization

Merger of Differentiated Products
A merger of firms 2 and 4 does nothing  now consider a merger between some of these firms A merger of firms 2 and 3 does something Price  a merger of non-neighboring firms has no effect  but a merger of neighboring firms changes the equilibrium r51 1 r12 2 r23 3 r34 4 r45 5 r51 Main Circle (flattened) EC 171: Topics in Industrial Organization

Merger of Differentiated Products
 merger of 2 and 3 induces them to raise their prices Price  so the other firms also increase their prices  the merged firms lose some market share  what happens to profits? r51 1 r12 2 r23 3 r34 4 r45 5 r51 Main Circle (flattened) EC 171: Topics in Industrial Organization

Spatial Merger (cont.)  The impact of the merger on prices and profits is as follows Pre-Merger Post-Merger Price Profit Price Profit tL/ tL2/25 1 1 14tL/ tL2/900 2 tL/ tL2/25 2 19tL/ tL2/7200 3 tL/ tL2/25 3 19tL/ tL2/7200 4 tL/ tL2/25 4 14tL/ tL2/900 5 tL/ tL2/25 5 13tL/ tL2/3600 EC 171: Topics in Industrial Organization

Spatial Merger (cont.) This merger is profitable for the merged firms And it is not the best that they can do change the locations of the merged firms expect them to move “outwards”, retaining captive consumers perhaps change the number of firms: or products on offer expect some increase in variety But consumers lose out from this type of merger all prices have increased For consumers to derive any benefits either increased product variety so that consumers are “closer” there are cost synergies not available to the non-merged firms e.g. if there are economies of scope Profitability comes from credible commitment EC 171: Topics in Industrial Organization

Price Discrimination  What happens if the firms can price discriminate?  This leads to a dramatic change in the price equilibrium Price p1i  take two neighboring firms p1i+1  consider a consumer located at s p2i  suppose firm i sets price p1i p*i(s)  i+1 can undercut with price p1i+1  i can undercut with price p2i  and so on  i wins this competition by “just” undercutting i+1’s cost of supplying s t t  the same thing happens at every consumer location i s i+1 Firm i supplies these consumers and firm i+1 these consumers  equilibrium prices are illustrated by the bold lines EC 171: Topics in Industrial Organization

Merger with price discrimination
This is much better for consumers than no price discrimination Merger with price discrimination Price equilibrium pre-merger is given by the bold lines Profit for each firm is given by the shaded areas  Start with a no-merger equilibrium 1 2 3 4 EC 171: Topics in Industrial Organization

Merger with price discrimination
This is beneficial for the merged firms but harms consumers Merger with price discrimination  Now suppose that firms 2 and 3 merge Prices to the captive consumers between 2 and 3 increase  They no longer compete in prices so the price equilibrium changes Profits to the merged firms increase 1 2 3 4 EC 171: Topics in Industrial Organization

Vertical Mergers Now consider very different types of mergers between firms at different stages in the production chain also applies to suppliers of complementary products These mergers turn out, in general, to be beneficial for everyone. EC 171: Topics in Industrial Organization

Complementary Mergers
Take a simple example: final production requires two inputs in fixed proportions one unit of each input is needed to make one unit of output input producers are monopolists final product producer is a monopolist demand for the final product is P = Q marginal costs of upstream producers and final producer (other than for the two inputs) normalized to zero. What is the effect of merger between the two upstream producers? EC 171: Topics in Industrial Organization

Complementary mergers (cont.)
Supplier 1 Supplier 2 price v2 price v1 Final Producer price P Consumers EC 171: Topics in Industrial Organization

Complementary producers
 Consider the profit of the final producer: this is pf = (P - v1 - v2)Q = (140 - v1 - v2 - Q)Q Solve this for Q  Maximize this with respect to Q pf/Q = 140 - (v1 + v2) - 2Q = 0  Q = 70 - (v1 + v2)/2  This gives us the demand for each input Q1 = Q2 = 70 - (v1 + v2)/2  So the profit of supplier 1 is then: p1 = v1Q1 = v1(70 - v1/2 - v2/2)  Maximize this with respect to v1 EC 171: Topics in Industrial Organization

Complementary producers (cont.)
The price charged by each supplier is a function of the other supplier’s price p1 = v1Q1 = v1(70 - v1/2 - v2/2) We need to solve these two pricing equations Solve this for v1  Maximize this with respect to v1 p1/v1 = 70 - v1 - v2/2 = 0 v1 = 70 - v2/2 v2  We can do exactly the same for v2 140 R1 v2 = 70 - v1/2 v1 = 70 - (70 - v1/2)/2 = 35 + v1/4 70 so 3v1/4 = 35 so v1 = $46.67 46.67 R2 and v2 = $46.67 v1 70 140 46.67 EC 171: Topics in Industrial Organization

Complementary products (cont.)
 Recall that Q = Q1 = Q2 = 70 - (v1 + v2)/2 so Q = Q1 = Q2 = units  The final product price is P = Q = $116.67  Profits of the three firms are then: supplier 1 and supplier 2: p1 = p2 = x = $1,088.81 final producer: pf = ( ) x = $544.29 EC 171: Topics in Industrial Organization

Complementary products (cont)
Now suppose that the two suppliers merge Supplier 1 Supplier 2 23.33 $46.67 each 23.33 $46.67 each Final Producer 23.33 $ each Consumers EC 171: Topics in Industrial Organization

Supplier 1 Supplier 2 price v The merger allows the two firms to coordinate their prices Final Producer price P Consumers EC 171: Topics in Industrial Organization

Complementary merger (cont.)
 Consider the profit of the final producer: this is pf = (P - v)Q = (140 - v - Q)Q Solve this for Q  Maximize this with respect to Q pf/Q = 140 - v - 2Q = 0  Q = 70 - v/2  This gives us the demand for each input Q1 = Q2 = Qm = 70 - v/2  So the profit of the merged supplier is: pm = vQm = v(70 - v/2)  Maximize this with respect to v EC 171: Topics in Industrial Organization

Complementary merger (cont.)
This is the cost of the combined input so the merger has reduced costs to the final producer pm = vQm = v(70 - v/2) The merger has reduced the final product price: consumers gain  Differentiate with respect to v pm/v = 70 - v = 0 so v = $70  Recall that Qm = Q = 70 - v/2 so Qm = Q = 35 units This is greater than the combined pre-merger profit  This gives the final product price P = Q = $105  What about profits? For the merged upstream firm: This is greater than the pre-merger profit pm = vQm = 70 x 35 = $2,480  For the final producer: pf = ( ) x 35 = $1,225 EC 171: Topics in Industrial Organization

A merger of complementary producers has increased profits of the merged firms increased profit of the final producer reduced the price charged to consumers Everybody gains from this merger: a Pareto improvement! Why? This merger corrects a market failure prior to the merger the upstream suppliers do not take full account of their interdependence reduction in price by one of them reduces downstream costs, increases downstream output and benefits the other upstream firm but this is an externality and so is ignored Merger internalizes the externality EC 171: Topics in Industrial Organization

Vertical Mergers The same kinds of result arise when we consider vertical mergers: mergers of upstream and downstream firms If the merging firms have market power lack of co-ordination in their independent decisions double marginalization merger can lead to a general improvement Illustrate with a simple model one upstream and one downstream monopolist manufacturer and retailer upstream firm has marginal costs $20 sells product to the retailer at price r per unit retailer has no other costs: one unit of input gives one unit of output retail demand is P = Q EC 171: Topics in Industrial Organization

Vertical merger (cont.)
Marginal costs $20 Manufacturer wholesale price r Price P Consumer Demand: P = Q EC 171: Topics in Industrial Organization

Consider the retailer’s decision identify profit-maximizing output set the profit maximizing price  marginal revenue downstream is MR = Q  marginal cost is r Price  equate MC = MR to give the quantity Q = (140 - r)/2 140 Demand  identify the price from the demand curve: P = Q = (140 + r)/2 (140+r)/2  profit to the retailer is (P - r)Q which is pD = (140 - r)2/4  profit to the manufacturer is (r-c)Q which is pM = (r - c)(140 - r)/2 r MC MR Quantity 140 - r 2 70 140 EC 171: Topics in Industrial Organization

 suppose the manufacturer sets a different price r1 Price  then the downstream firm’s output choice changes to the output Q1 = (140 - r1)/2 140 Demand  and so on for other input prices r1  demand for the manufacturer’s output is just the downstream marginal revenue curve r MC Upstream demand MR Quantity 140 - r 2 70 140 140 - r1 2 EC 171: Topics in Industrial Organization

 the manufacturer’s marginal cost is $20  upstream demand is Q = (140 - r)/2 which is r = Q Price  upstream marginal revenue is, therefore, MRu = Q 140 110  equate MRu = MC: Q = 20 Demand  so Q* = 30 and the input price is $80 80  while the consumer price is $110 Upstream demand  the manufacturer’s profit is $1800 20  the retailer’s profit is $900 MC MRu MR Quantity 35 70 140 30 EC 171: Topics in Industrial Organization

Now suppose that the retailer and manufacturer merge manufacturer takes over the retail outlet retailer is now a downstream division of an integrated firm the integrated firm aims to maximize total profit Suppose the upstream division sets an internal (transfer) price of r for its product Suppose that consumer demand is P = P(Q) Total profit is: upstream division: (r - c)Q downstream division: (P(Q) - r)Q aggregate profit: (P(Q) - c)Q The internal transfer price nets out of the profit calculations Back to the example EC 171: Topics in Industrial Organization

This merger has benefited consumers This merger has benefited the two firms  the integrated demand is P(Q) = Q  marginal revenue is MR = Q Price  marginal cost is $20 140  so the profit-maximizing output requires that Q = 20  so Q* = 60 Demand  so the retail price is P = $80 80  aggregate profit of the integrated firm is ( )x60 = $3,600 20 MC MR Quantity 60 70 140 EC 171: Topics in Industrial Organization

Integration increases profits and consumer surplus Why? the firms have some degree of market power so they price above marginal cost so integration corrects a market failure: double marginalization What if manufacture were competitive? retailer plays off manufacturers against each other so obtains input at marginal cost gets the integrated profit without integration Why worry about vertical integration? two possible reasons price discrimination vertical foreclosure EC 171: Topics in Industrial Organization

Price discrimination Upstream firm selling to two downstream markets different demands in the two markets  the seller wants to price discriminate between these markets v1 v2  set v1 < v2  but suppose that buyers can arbitrage va Market 1 Market 2  then buyer 2 offers to buy from buyer 1 at a price va such that v1 < va < v2 P P  arbitrage prevents price discrimination  if the seller integrates into market 1 arbitrage is prevented D1 D2 Q Q EC 171: Topics in Industrial Organization

Vertical foreclosure Vertically integrated firm refuses to supply other firms so integration can eliminate competitors  suppose that the seller is supplying three firms with an essential input  the seller integrates with one buyer  if the seller refuses to supply the other buyers they are driven out of business  is this a sensible thing to do? EC 171: Topics in Industrial Organization

Vertical foreclosure The integrated firm will
not source on the independent market  Suppose that there are some integrated firms and some independent upstream and downstream producers  Profit of an integrated firm is: The integrated firm will not sell on the independent market pI = (PD - cU - cD)qDi  Profit of an independent upstream firm is: pU = (PU - cU)qUn  Profit of an independent downstream firm is: pD = (PD - PU - cD)qDn EC 171: Topics in Industrial Organization

Vertical foreclosure  For the independent upstream firms to survive requires PU - cU > 0  The downstream unit of an integrated firm obtains input at cost cU  Buying from an independent firm costs PU > cU so the downstream divisions will not source externally  Now suppose that an upstream division of an integrated firm is selling to independent downstream firms it earns PU - cU on each unit sold But this is true: so diverting output from the external market increases profits Profit from selling externally  Divert one unit to its downstream division: this leaves the downstream price unchanged: Profit from selling internally it earns PD - cU - cD on this unit diverted PD - PU - cD > 0 for independent downstream firms to survive PD - cU - cD > PU - cU requires: PD - PU - cD > 0 so the upstream divisions will not sell externally EC 171: Topics in Industrial Organization

Vertical foreclosure (cont.)
Foreclosure happens but is not necessarily harmful to consumers reduces number of buyers in the upstream market increases prices charged by independent sellers to non-integrated downstream firms but integrated downstream divisions obtain inputs at cost puts pressure on non-integrated downstream firms provided there are “enough” independent upstream firms the anti-competitive effects of foreclosure will be offset by the cost advantages of vertical integration There are also strategic effects that might prevent foreclosure to avoid non-integrated firms from integrating EC 171: Topics in Industrial Organization

EC 171: Topics in Industrial Organization

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