Issues in Vertical Integration
Vertical Non-Integration
Supplier 1
Supplier 2
Supplier 3 Upstream
The Firm
Distributor 1
Distributor 2
Consumers
Distributor 3 Downstream
Vertical Integration
Supplier 1
Supplier 2
Supplier 3 Upstream
The Firm
Distributor 1
Distributor 2
Consumers
Distributor 3 Downstream
Problems Facing the Non–
Integrated Firm
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Double marginalization
Hold-up & other bargaining problems
Threat of vertical foreclosure
Downstream free-riding
Market-Power Pricing: A Review
$/unit
MC
p*
CS
DWL
profit
Demand
Q*
Quantity
MR
Double Marginalization
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Consider two independent firms,
upstream and downstream, that each
have market power (i.e., perceive themselves
as facing downward sloping firm-specific demand).
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Each firm then prices at a mark up over
marginal cost.
Recall that pricing above MC yields
deadweight losses
Now these are being incurred twice!
Double Marginalization
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If upstream and downstream merge,
then upstream ceases to try to capture
surplus from downstream.
Upstream prices (transfers) at MC.
One deadweight loss eliminated.
Like picking money up off the table!
A Digression: Transfer Pricing
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Within a firm, goods should always be
transferred at marginal cost (otherwise
firm imposes a deadweight loss on
itself).
Note marginal cost needs to be
calculated using opportunity cost.
Example
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Upstream division incurs constant production
marginal cost of $1 per unit.
Upstream division also sells outside the firm
at a price of $4 per unit.
If upstream division operating at capacity,
then transfer price = $4, since that’s the
opportunity cost of internal transfer. Decision
is who not whether!
If not at capacity, then transfer price = $1, the
production MC. Decision is whether not who!
Competitive Markets & Double
Marginalization
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If the upstream supplier is in a
competitive mkt. (alternatively, in the
Bertrand trap), then it prices at MC.
Consequently, no deadweight loss.
Impossible to get good for less.
Double-marginalization (i.e., transferpricing) justifications for merging do not
apply.
Comp. Mkts. & Double Marg.
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If downstream is competitive, then it’s
pricing at MC.
It’s, therefore, not creating one of the
two deadweight losses.
Hence, there’s nothing to pick up off the
table vis-à-vis double marginalization—
again not a motive to merge.
Hold-ups & Bargaining Issues
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Firms often need to make transactionspecific investments.
E.g., a mold built to stamp out GM
fenders can’t be used for Ford fenders.
This creates the danger of hold-up
(opportunism).
After one firm (e.g., Fisher Body) makes
investment, investment is sunk and
subsequent bargaining w/ other firm (e.g.,
GM) could lead to returns that are too low.
Example
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Upstream invests $12 million on transactionspecific investment.
MC for upstream for parts is $10.
A million units to be traded.
Downstream’s value is $30/part.
Surplus from post-investment trade =
$20/unit.
Suppose bargaining splits surplus evenly,
then upstream gets paid $20/unit; so gross
profit is $10 million.
But this is less than investment cost!
Contractual Solutions
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Obviously, should fix price in advance at
$22 or more per part!
But in many cases this will create
agency problems.
If quality, delivery time, etc., matter, what
incentive does upstream now have to do
good job given guaranteed price?
But w/o guaranteed price, upstream
subject to hold-up.
Example: Disney & Pixar
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Disney wants Pixar to make computeranimated film, Toy Story, which Disney
will market.
Given Disney’s expertise in mkt’ing
animated films, relationship makes
sense.
What contract to write?
Disney & Pixar (cont.)
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If Disney fixes price in advance, then
Pixar’s incentives are blunted.
If parties wait to negotiate price after
Pixar produces film, then Pixar’s
incentives better, but now problem of
hold-up.
Possible solution: option contract.
Option Contract
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Contract fixes price if trade, but gives
Disney right to refuse to trade.
If Pixar doesn’t make sufficiently good
film, then Disney lets its option to buy
expire.
If Pixar does make sufficiently good film,
then Disney will want to exercise.
Renegotiation
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A problem with any contract is that it
can be renegotiated.
Hence, if outcome arises in which
exercising contract as written would
leave surplus on table, then parties will
renegotiate.
However, the anticipation of
renegotiation can distort ex ante
incentives.
Renegotiation
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This can undo the option-contract
solution
What ultimately matters is which of two
effects dominates
hold-up effect
threat-point effect
Threat-point Effect
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Our assumption of wholly specific
investment is often unrealistic—good
could have a lower, general value (e.g.,
Warner Bros. could mkt. Toy Story).
Does gen’l value increase more at margin
w/ investment than specific value?
If so, threat-point effect dominates and
efficiency can be achieved.
If not, hold-up effect dominates and
inefficient outcome.
Other Solutions to Hold-up
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Keep markets thick:
harder to be held up if you have alternative
suppliers or distributors to use.
additional benefits of diversification (e.g.,
not hosed if supplier’s factory burns down).
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Develop reputation for cooperation
rather than opportunism.
works if PDV of cooperate > PDV of
opportunism today and non-cooperation
tomorrow.
Reputation
payoff
cooperate
opportunistic
0
1
2
...
time
Merge to Avoid Hold-up
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Merger serves to limit danger of hold-up
Merger, however, doesn’t miraculously
cure agency problems.
still need to provide incentives to upstream
& downstream managers
dangers in how this is done (e.g., could be
mistake to turn upstream into profit
center—usually better to make cost
center).
Vertical Foreclosure
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Market power in one stream can be
extended to another through vertical
foreclosure.
U1
D1
U2
D2
D3
Vertical Foreclosure
U1
D1
U2
D2
D3
D2 and D3 at cost disadvantage, since U2 has market power.
U2 may not do as well as U1 because of double marginalization.
Vertical Foreclosure
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Also deters entry
locking up suppliers
locking up buyers
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Not surprisingly, vertical mergers also
receive antitrust scrutiny.
Downstream Free-riding
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Suppose downstream is retail level.
Two retailers:
one provides customer information on
product, customer service, etc.
other just sells product w/o doing any of that.
Problem:
the 2nd has cost advantage and can charge
lower price
customers get info., service, etc. from 1st,
but buy from 2nd.
Free-riding
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1st retailer can’t compete unless drops
services.
But this could hurt manufacturer in
terms of decreasing overall demand for
product.
Solution:
force all retailers to charge same price
(resale price maintenance)
Problem: RPM is generally illegal
Free-riding
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Consequence: May have to merge into
retailing to preserve service, etc.
Consequence: Franchising (some problems)
Consequence: Provide alternative
motives for retailers to keep margins up.
participation in joint advertising campaigns
treatment (e.g., how fast restocked, etc.)
ability to carry product at all (e.g., drop
those not providing service)
Problems Facing Integrated Firm
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Detraction from core competencies.
Difficulty of selective intervention.
Incompatible cultures.
Product market is a very good incentive
device—hard to duplicate internally.
Financial markets are very good
incentive devices—hard to duplicate
internally.
Captive market can inhibit innovation.