Downstream Competition, Foreclosure, and Vertical Integration

DISCUSSION PAPER SERIES

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No. 2647 DOWNSTREAM COMPETITION, FORECLOSURE AND VERTICAL INTEGRATION Gilles Chemla INDUSTRIAL ORGANIZATION

ISSN 0265-8003

DOWNSTREAM COMPETITION,

FORECLOSURE AND

VERTICAL INTEGRATION

Gilles Chemla, University of British Columbia,

THEMA, and CEPR

Discussion Paper No. 2647 December 2000

Centre for Economic Policy Research 90–98 Goswell Rd, London EC1V 7RR, UK Tel: (44 20) 7878 2900, Fax: (44 20) 7878 2999

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CEPR Discussion Paper No. 2647 December 2000

ABSTRACT

Downstream Competition, Foreclosure and Vertical Integration*

This Paper analyses the impact of competition among downstream firms on an upstream firm’s pay-off and on its incentive to vertically integrate when firms on both segments negotiate optimal contracts. We argue that tougher competition decreases the downstream industry profit, but improves the upstream firm’s negotiation position. In particular, the upstream firm is better off encouraging competition when the downstream firms have high bargaining power. We derive implications on the interplay between vertical integration and competition among the downstream firms. The mere possibility of vertical integration may constitute a barrier to entry and may trigger strategic horizontal spin-offs or mergers. We discuss the impact of upstream competition on our results.

JEL Classification: D40, L10, L42

Keywords: bargaining, competition, contracts, foreclosure, vertical integration Gilles Chemla

Faculty of Commerce & Business Administration University of British Columbia

2053 Main Hall Vancouver British Columbia, V6T 1Z2 CANADA Tel: (1 604) 822 8490 Fax: (1 604) 822 8521 Email: gilles.chemla@commerce.ubc.ca

* I would like to thank University of British Columbia, THEMA (CNRS), and CEPR. I am particularly indebted to Patrick Bolton, Antoine Faure-Grimaud, Denis Gromb, John Moore, Patrick Rey, Jean Tirole and two anonymous referees for long conversations and/or very thoughtful comments which have greatly improved the quality of this Paper. I am also grateful to Torkild Byg, Sorbas von Coester, Leonardo Felli, Jan Mahrt-Smith and seminar participants at the 11th World Congress of the International Economic Association, the 1996 North American Winter Meeting of the Econometric Society, the Canadian Economic Association 2000 Meetings, CSIC – Universitat Autonoma de Barcelona, Seminaire Fourgeaud (CERAS), HEC Graduate School of Management, London School of Economics, THEMA, Universitat Pompeu Fabra, the University of British Columbia and the University College of London for helpful discussions on early drafts. Financial support from the Social Sciences and Humanities Research Council is gratefully acknowledged. All errors are mine.

NON-TECHNICAL SUMMARY

In many competition policy cases, a dominant firm, say an upstream firm, is suspected to restrict access to an essential input to some downstream firms in order to extend its monopoly power to the downstream industry. In particular, the tendency by the upstream firm to engage in so-called market foreclosure would provide an important rationale for government intervention. This intervention can be as dramatic as the break-up of a large company, as advocated by many in the ongoing Microsoft case.

The present Paper aims to provide a caveat to the view that dominant firms necessarily want to extend their monopoly power to vertically related markets. An important intuition behind the market foreclosure argument is that the use of vertical restraints such as (price) discrimination, non-linear tariffs and/or vertical integration may allow the upstream firm to increase the downstream industry profit and appropriate it (Rey and Tirole, 1999). This effect is typically modelled through optimal take-it-or-leave-it contract offers made by a monopolistic upstream firm to downstream firms that compete for both input and output. In this Paper, we observe that a monopolistic upstream firm need not have all the bargaining power as, for instance, the mere threat of the appearance of an alternative source of supply would increase the downstream firms’ bargaining power. We thus allow the upstream firm and downstream firms to bargain over optimal tariffs. We argue that a monopolistic upstream firm that can use vertical restraints may then be willing to favour downstream competition.

When the tariffs are negotiated, the use of vertical restraints allows the upstream firm to appropriate only part of the downstream industry profit. When a downstream firm makes a contract offer, it sees itself as the incremental downstream firm. Then, when the cost to the upstream firm of servicing an additional downstream firm is convex, the contract offer made by each firm increases with the number of downstream firms. Thus, downstream competition improves the upstream firm’s negotiation position. Therefore, when downstream firms have high bargaining power, the upstream firm is better off with more downstream competition. Therefore, the foreclosure result relies heavily on the extreme assumption that the upstream firm has all the bargaining power.

This negotiation effect may actually be so strong that the upstream firm’s incentive to favour downstream competition is sometimes higher than that of a social planner. When the downstream firms make contract offers, the upstream firm ignores both the positive effect of an increase in competition (and production) to consumers and the negative effect to downstream firms. The additional cost of servicing one more firm is borne by the downstream firms and it benefits the upstream firm even though this cost is higher than the positive effect on consumers of increasing production.

This approach allows us to derive predictions on the interactions between vertical integration and the competitive environment. Vertical integration allows the upstream firm to increase her leverage on the downstream industry. When she appropriates (a share of) the downstream industry surplus and when the supplier’s bargaining power is low (or high), the benefit from vertical integration increases (or decreases) with downstream competition. Ex ante, the possibility of vertical integration has important consequences on market structure. Entry in the downstream industry may be restricted by the mere threat of vertical integration. Strategic horizontal mergers or spin-offs may be observed in order to prevent vertical integration. The case where two upstream firms compete to supply downstream firms is discussed.

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