Skip to main content

Advertisement

SpringerLink
Log in

Vertical integration, market foreclosure and quality investment

  • Original Article
  • Published:
Portuguese Economic Journal Aims and scope Submit manuscript

Abstract

We study incentives to vertically integrate in an industry with vertically differentiated downstream firms. Vertical integration by one of the firms increases production costs for the rival. Increased production costs negatively affects quality investment both by the integrated firm and the unintegrated rival. Quality investment by both firms decreases under any (vertical integration) scenario. The decrease in quality invesment by both firms softens competition among downstream firms. By integrating first, a firm always produces the high quality good and earns higher profits. A fully integrated industry, with increased product differentiation, is observed in equilibrium. Due to increase in firm profits, social welfare under this structure is greater than under no integration.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Fig. 1
Fig. 2
Fig. 3
Fig. 4

Similar content being viewed by others

Notes

  1. OECD 2007, Policy Roundtable on Vertical Mergers, http://www.oecd.org/dataoecd/25/49/39891031.pdf.

  2. This results does not hold when firms merge simultaneously in the first stage. The strategic motive of raising rivals’ costs, which is the focus of most papers, is lost in simultaneous vertical mergers.

  3. The effect of reducing competition in the output stage by increasing input costs has been studied by Salop and Scheffman (1983, 1987).

  4. Without competing with the remaining upstream firm.

  5. This assumption has been criticized in the literature (see Reiffen 1992 and Avenel and Barlet 2000).

  6. See Ordover et al. (1990) and Hart and Tirole (1990).

  7. In his model, there are several firms that supply the input. However, only two of them invest in R&D to obtain new technology.

  8. We would like to thank one of the referees for pointing this out.

  9. The quality investment structure in our model is the same as in Motta (1993).

  10. See Shaked and Sutton (1983).

  11. We use the standard product differentiation developed in Shaked and Sutton (1983). Also see Motta (1993).

  12. One can formulate the bidding at this stage in several ways. One can use the structure in OSS, which we use. OSS then study the robustness of their results with two different formulations. In one, upstream firms bid, and in the other, downstream firms bid for the two upstream firms. Their main results do not change. Only bids and distribution of profits are different in the first case.

  13. Given the symmetry of the upstream firms, we denote the integrated firm, between D i and U i , as F i .

  14. The advantage of price competition is that it isolates the problem of the strategic value of vertical integration for the integrating firm. For a detailed discussion see OSS.

  15. The incentives to foreclose potential entrants using exclusive contracts has been studied by Aghion and Bolton (1987) and Rasmusen et al. (1991). More recently, Chen and Riordan (2007) analyze the incentives of an integrated firm to foreclose an un-integrated (equally, or more efficient) upstream rival signing an exclusive contract.

  16. As in Salinger (1988) and OSS. OSS’s commitment is more complex. They assume that the integrated firm can decide either to not sell the product to its rival, or to supply it if the remaining unintegrated downstream firm is setting a high price. This assumption has been criticized by Reiffen (1992).

  17. The evidence of foreclosure in empirical studies is inconclusive (see Lafontaine and Slade 2007 and Cooper et al. 2005, for an extensive review of this literature). Martin et al. (2001) find evidence of foreclosure in an experimental market. In their design, the vertically integrated firm forecloses its downstream rival in 73% of the cases, with the unintegrated firm profits being only 4% of the industry profits.

  18. For example, Chen (2001) substitutes the need for commitment with switching costs of one input for another. While, Avenel and Barlet (2000) and Choi and Yi (2000) allow the integrated firm to choose a specific technology, resulting in their inputs not being perfect substitutes.

  19. This is along the lines of the argument made by the OECD. Vertical integration can produce an increase in market power due to lowered quality investment.

  20. We maintain the notation followed by OSS.

  21. There is a symmetrical equilibrium with firm D 1 (D 2) producing low (high) quality.

  22. Using the same reasoning as in the FI 1 case.

  23. Note that the subsequent offer is also decreasing in the high quality level.

  24. High quality firm takes advantage of the lessening competiton: low quality falls from \(s_{2}^{NI}=0.090223\bar{\theta}^{2}\) to \(s_{2}^{FI_{H}}=0.039411 \bar{\theta}^{2}\).

  25. Note that under simultaneous integration, only profit redistribution takes place with total welfare remaining unchanged.

  26. This result is obtained in our model only if the firms integrate simultaneously. OSS only consider sequential integration. Allowing for simultaneous integration in their model, one obtains a totally integrated industry (as in our case).

  27. Profits before making the integration bid.

  28. See Hart and Tirole (1990), Ordover et al. (1992), Reiffen (1992) and Avenel and Barlet (2000) for a detailed discussion.

References

  • Aghion P, Bolton P (1987) Contracts as a barrier to entry. Am Econ Rev 77:338–401

    Google Scholar 

  • Avenel E, Barlet C (2000) Vertical foreclosure, technological choice, and entry on the intermediate market. J Econ Manage Strategy 9:211–230

    Article  Google Scholar 

  • Banerjee S, Lin P (2003) Downstream R&D, raising rivals costs and input price contracts. Int J Ind Organ 21:79–96

    Article  Google Scholar 

  • Brocas I (2003) Vertical integration and incentives to innovate. Int J Ind Organ 21:457–488

    Article  Google Scholar 

  • Chen Y (2001) On vertical mergers and their competitive effects. RAND J Econ 32:667–685

    Article  Google Scholar 

  • Chen Y, Riordan M (2007) Vertical integration, exclusive dealing, and ex post cartelization. RAND J Econ 38:1–21

    Article  Google Scholar 

  • Choi JP, Yi S (2000) Vertical foreclosure with the choice of input specifications. RAND J Econ 31:717–743

    Article  Google Scholar 

  • Cooper J, Froeb L, O’Brien D, Vita M (2005) Vertical antitrust policy as a problem of inference. Int J Ind Organ 23:639–664

    Article  Google Scholar 

  • Economides N (1998) The incentive for non-price discrimination by an input monopolist. Int J Ind Organ 16:271–284

    Article  Google Scholar 

  • Foros O (2004) Strategic investments with spillovers, vertical integration and foreclosure in the broadband access market. Int J Ind Organ 22:1–24

    Article  Google Scholar 

  • Hart O, Tirole J (1990) Vertical integration and market foreclosure. Brookings Pap Econ Act Microecon 1990:205–276

  • Lafontaine F, Slade M (2007) Vertical integration and firm boundaries: the evidence. J Econ Lit 45:629–685

    Article  Google Scholar 

  • Martin S, Normann H, Snyder C (2001) Vertical foreclosure in experimental markets. RAND J Econ 32:466–496

    Article  Google Scholar 

  • Motta M (1993) Endogenous quality choice: price vs. quantity competition. J Ind Econ 2:113–132

    Article  Google Scholar 

  • OECD (2007) Policy roundtable on vertical mergers. http://www.oecd.org/dataoecd/25/49/39891031.pdf

  • Ordover JA, Saloner G, Salop SC (1990) Equilibrium vertical foreclosure. Am Econ Rev 80:127–142

    Google Scholar 

  • Ordover J, Salonerm G, Salop S (1992) Equilibrium vertical foreclosure: reply. Am Econ Rev 82:698–703

    Google Scholar 

  • Rasmusen E, Ramseyer J, Wiley J (1991) Naked exclusion. Am Econ Rev 81:1137–1145

    Google Scholar 

  • Reiffen D (1992) Equilibrium vertical foreclosure: comment. Am Econ Rev 82:694–697

    Google Scholar 

  • Salinger M (1988) Vertical mergers and market foreclosure. Q J Econ 103:345–356

    Article  Google Scholar 

  • Salop S, Scheffman D (1983) Recent advances in the theory of industrial structure. raising rivals’ costs. Am Econ Rev: Pap Proc 73:267–271

    Google Scholar 

  • Salop S, Scheffman D (1987) Cost-raising strategies. J Ind Econ 36:19–34

    Article  Google Scholar 

  • Shaked A, Sutton J (1983) Natural oligopolies. Econometrica 51:1469–1483

    Article  Google Scholar 

  • Sibley D, Weisman D (1998) Raising rivals’ costs: the entry of an upstream monopolist into downstream markets. Inf Econ Policy 10:451–470

    Article  Google Scholar 

  • Stefanadis C (1997) Downstream vertical foreclosure and upstream innovation. J Ind Econ 45:445–456

    Article  Google Scholar 

  • Vickers J (1995) Competition and regulation in vertically related markets. Rev Econ Stud 62:1–17

    Article  Google Scholar 

Download references

Acknowledgements

Hernan and Kujal acknowledge support from grant 2009/00055/001 from the Spanish Ministry of Education. Kujal acknowledges support from the Instituto Universitario de Economía, Consolider-Ingenio 2010 and the Comunidad de Madrid (grant Excelecon).

Author information

Authors and Affiliations

  1. Economic Science Institute, Chapman University, One University Drive, CA 92866, Orange, USA

    Roberto Hernán González

  2. Departamento de Economía, Universidad Carlos III de Madrid, Calle Madrid 126, 28903, Getafe, Spain

    Praveen Kujal

Authors
  1. Roberto Hernán González
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Praveen Kujal
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Roberto Hernán González.

About this article

Cite this article

Hernán González, R., Kujal, P. Vertical integration, market foreclosure and quality investment. Port Econ J 11, 1–20 (2012). https://doi.org/10.1007/s10258-011-0074-z

Download citation

  • Received:

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s10258-011-0074-z

Keywords

JEL Classification

Search

Navigation