Vertical integration Economic Issues Miguel A. Fonseca

Readings See course webpage for additional reading for bank runs section! E3028/bee3028.htm Ch. 22, Church and Ware Ch 9, Martin

Recap In the last class we overviewed some of the theory and policy on horizontal mergers. They are cases where firms who compete in the same market act to form a single company. We now turn to a different case, vertical mergers, or vertical integration. Here, the focus is on the incentives for a firm to merge/acquire an upstream supplier or a downstream client.

Why should a firm acquire a supplier? If markets are efficient, firms will sell their output at marginal cost. That means that it is just as cheap to buy from an external supplier as producing in-house. Several problems do occur in the real world: –Incomplete contracts; –Hold-up; –Supplier market may not be perfectly competitive.

Double marginalisation Let’s consider the case of an upstream firm (supplier) producing an intermediate good, and a downstream firm (retailer) producing a consumer good. Demand for the final good is linear: P = a - bQ The marginal cost of producing a unit of the intermediate good is constant and equal to c. Let’s first consider if the two firms merge and act as a single company.

a (a+c)/2 c MR (a-c)/2b Monopoly Solution Q P

The case of separate companies Now let’s assume both firms are separate monopolies. Lets call the price the retailer pays the supplier for each unit be equal to r. The retailer will maximise profits: –Π r = (P- r)Q –Q* = (a-r)/2b, P*= (a+r)/2.

Double marginalisation (cont.) So the demand for the intermediate good is Q = (a-r)/2b Inverting it as a function of the price of the intermediate good gives: r = a – 2bQ (note that this is the same as the retailer’s MR curve) So the supplier maximises her profits [Π s = (r-c)Q] with respect to Q: This gives Q = (a-c)/4b. r = (a+c)/2.

Double marginalisation (cont.) Recall the optimal output and price by retailer: Q* = (a-r)/2b, P*= (a+r)/2. Plugging r = (a+c)/2 into the equilibrium output and price of the retailer, we get: Q* = (a-c)/4b and P* = (3a+c)/4. Both the consumer surplus AND the sum of firms’ profits are lower with separate companies!

Double Marginalization a (3a+c)/4 (a+c)/2 c MR for retailer (a-c)/2b MR for manufacturer P Q

Double marginalisation (cont.) How can this be tackled? Two-part tariff (franchising): –Supplier charges a Fixed fee F to sell the good to retailer and sells each unit at marginal cost. –F should not affect retailer price, as the key condition is that MR = MC. Royalty arrangement –Supplier sells goods at MC but earns a percentage of profits.

Tying Requirements tying is a practise whereby a monopoly manufacturer of good A requires customers to also purchase a another good B from itself. In other words, the monopolist leverages its market power from one market to the other. The two goods may or may not be complements. E.g. Cameras and film, copiers and toner, operating systems and software applications.

Microsoft vs. EU Commission In 2000, the commission expanded the investigation to include the effects of tying Windows Media Player (WMP) with Windows The investigation found that this tying practise significantly reduced the incentives of media content companies to offer their products to competing firms on the media player market. See also discussion in Church & Ware concerning US vs. Microsoft regarding tying practises in the web browser market.