Issues in Vertical Integration

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Issues in Vertical Integration
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Vertical Non-Integration
Supplier 1
Supplier 2
Supplier 3
Upstream
The Firm
Distributor 1
Distributor 2
Distributor 3
Downstream
Consumers
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Vertical Integration
Supplier 1
Supplier 2
Supplier 3
Upstream
The Firm
Distributor 1
Distributor 2
Distributor 3
Downstream
Consumers
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Problems Facing the NonIntegrated Firm

• Double marginalization
• Hold-up other bargaining problems
• Threat of vertical foreclosure
• Downstream free-riding

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Market-Power Pricing A Review
/unit
MC
CS
p
DWL
profit
Demand
Quantity
Q
MR
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Double Marginalization

• Consider two independent firms, upstream and
  downstream, that each have market power (i.e.,
  perceive themselves as facing downward sloping
  firm-specific demand).
• 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!

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Double Marginalization

• 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!

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A Digression Transfer Pricing

• 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.

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Example

• 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 thats 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!

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Competitive Markets Double Marginalization

• 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., transfer-pricing)
  justifications for merging do not apply.

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Comp. Mkts. Double Marg.

• If downstream is competitive, then its pricing
  at MC.
• Its, therefore, not creating one of the two
  deadweight losses.
• Hence, theres nothing to pick up off the table
  vis-à-vis double marginalization again not a
  motive to merge.

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Hold-ups Bargaining Issues

• Firms often need to make transaction-specific
  investments.
• E.g., a mold built to stamp out GM fenders cant
  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.

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Example

• Upstream invests 12 million on
  transaction-specific investment.
• MC for upstream for parts is 10.
• A million units to be traded.
• Downstreams 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!

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Contractual Solutions

• 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.

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Example Disney Pixar

• Disney wants Pixar to make computer-animated
  film, Toy Story, which Disney will market.
• Given Disneys expertise in mkting animated
  films, relationship makes sense.
• What contract to write?

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Disney Pixar (cont.)

• If Disney fixes price in advance, then Pixars
  incentives are blunted.
• If parties wait to negotiate price after Pixar
  produces film, then Pixars incentives better,
  but now problem of hold-up.
• Possible solution option contract.

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Option Contract

• Contract fixes price if trade, but gives Disney
  right to refuse to trade.
• If Pixar doesnt 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.

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Renegotiation

• 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.

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Renegotiation

• This can undo the option-contract solution
• What ultimately matters is which of two effects
  dominates
• hold-up effect
• threat-point effect

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Threat-point Effect

• Our assumption of wholly specific investment is
  often unrealisticgood could have a lower,
  general value (e.g., Warner Bros. could mkt. Toy
  Story).
• Does genl 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.

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Other Solutions to Hold-up

• 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 suppliers factory burns down).
• Develop reputation for cooperation rather than
  opportunism.
• works if PDV of cooperate gt PDV of opportunism
  today and non-cooperation tomorrow.

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Reputation
payoff
cooperate
opportunistic
time
0
1
2
...
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Merge to Avoid Hold-up

• Merger serves to limit danger of hold-up
• Merger, however, doesnt 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
  centerusually better to make cost center).

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Vertical Foreclosure

• Market power in one stream can be extended to
  another through vertical foreclosure.

U1
U2
D2
D1
D3
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Vertical Foreclosure
U1
U2
D2
D1
D3
D2 and D3 at cost disadvantage, since U2 has
market power. U2 may not do as well as U1 because
of double marginalization.
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Vertical Foreclosure

• Also deters entry
• locking up suppliers
• locking up buyers
• Not surprisingly, vertical mergers also receive
  antitrust scrutiny.

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Downstream Free-riding

• 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.

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Free-riding

• 1st retailer cant 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

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Free-riding

• 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)

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Problems Facing Integrated Firm

• Detraction from core competencies.
• Difficulty of selective intervention.
• Incompatible cultures.
• Product market is a very good incentive
  devicehard to duplicate internally.
• Financial markets are very good incentive
  deviceshard to duplicate internally.
• Captive market can inhibit innovation.