Vertical integration

1. Vertical integration Economic Issues Miguel A. Fonseca m.a.fonseca@exeter.ac.uk

2. Readings • See course webpage for additional reading for bank runs section! • http://www.people.ex.ac.uk/nh205/Teaching/BEE3028/bee3028.htm • Ch. 22, Church and Ware • Ch 9, Martin

3. 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.

4. 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.

5. 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.

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

7. 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: • Πr = (P- r)Q • Q* = (a-r)/2b, P*= (a+r)/2.

8. 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 [Πs = (r-c)Q] with respect to Q: • This gives Q = (a-c)/4b. r = (a+c)/2.

9. 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!

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

11. 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.

12. 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.

13. Microsoft vs. EU Commission • In 2000, the commission expanded the investigation to include the effects of tying Windows Media Player (WMP) with Windows 2000. • 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.