Vertical integration
Suppose two manufacturers vertically integrated. All cost and demand functions are common knowledge. each manufacturer sells via a retailer:
d4 is the retailer who sells good 1
d5 is the retailer who sells good 2.
There are then two competing vertical chains. the manufacturer chooses the retailer, do the retailer it has all the bargaining power.
a retailer has an incentive to respond to a price increase of the rival, by increasing the price himself. the manufacturer’s incentive to increase the wholesale price.
By creating a monopolist (or several monopolists) downstream, they strategically relax competition.
by adding more and more layers [of vertical restraints],(for instance, by creating wholesalers and other intermediaries between production and retail), manufacturers may get the monopoly (i.e. the joint-profit maximising) prices, to induce higher prices.
Competition reduces the risk that vertical restraints lower welfare
strategic substitutes:
-when firms delegate they sell a higher ąuantity than under vertical integration.
-prisoner’s dilemma: both firms end up in an better o if they were not allowed to contract with independent retailers!
-vertical restraints increase welfare..as they can facilitate collusion….how?:
- rpm favours collusion among manufacturers.
- when manufacturers sell through a common retailer, they might reach the collusive outcome.
1 – RPM favours collusion
rpm facilitates collusion among manufacturers, because it increases price observability. Absent RPM, when shocks in the retail markets occur, final (retail) prices change, making it more difficult for manufacturers to distinguish changes [in retail prices] caused by different retail conditions, from cheating on the cartel. RPM makes collusion more likely by eliminating the retail price variation
2- manufacturers sell through a common retailer (agent)
If two manufacturers decide to sell their goods in the final market via a common agent (or retailer), this might have anti-competitive effects, if it causes joint profit maximising prices being charged at eąuilibrium….this can happen in 2 poss situations:
1- if the manufacturers offer a two-part tari contract to the common retailer, and delegate the price decisions to it. it is obvious that the common agent will pick the collusive prices. Manufacturers would still compete on wholesale prices, but have no incentive to set wholesale prices higher than their own marginal cost. As a result, the retailer behaves exactly as if the manufacturers sold directly to the final market and could maximise joint profits.
2- collusive prices can be obtained, even if the price choices were not delegated to the common retailer. If two manufacturers offer a franchise fee contract, to a common retailer, but also impose its final price (in other words, RPM is allowed). then, at eąuilibrium, both firms choose the collusive price. This is because each manufacturer makes the retailer the residual claimant and uses the franchise fee to recover its profit. At the moment of setting the final resale price, each manufacturer takes into account that the final profit of the retailer depends not only on the sales of the manufacturer’s product itself, but also on the sales of the rival’s product. This way, when a manufacturer chooses its price so as to maximise the retailer’s profit it takes into account the externality that the price decision has on the retailer’s profit that comes from the sales of the rival product: this is precisely the same as when the two products were sold by the same cartel (i.e., under joint profit maximisation).
Anti-competitive effects: leverage and foreclosure:
May a firm use anti-competitive practices to protect and reinforce its map in one market, or to extend it to other markets?:
anticomps should be balanced against possible efficiency effects from:
a.exclusive contracts
b.vertical mergers.
a. Positive efficiencies from Exclusive contracts
The concern that a dominant firm might use exclusive contracts to cause foreclosure [=damage actual or potential competitors], is unfounded, due to the efficiency effects of exclusive contracts.
Suppose for instance there is an incumbent monopolist, a potential entrant (more efficient than the incumbent) and only one buyer. By accepting an exclusive dealing contract, a buyer would commit to buy from a monopolist even if entry occurs. This rules out entry, and the buyer will end up paying the monopoly price. By rejecting the contract offer, instead, the buyer would trigger entry and benefit from a lower price. Sure enough, the incumbent might offer a compensation to the buyer to persuade her to accept exclusivity. However, the incumbent is willing to pay a compensation no higher than its monopoly profit, whereas the buyer – by accepting the exclusive contract – would lose all the consumer surplus that arises by buying at lower prices
Thus, exclusive contracts only exist where they entai efficiency gains, but since these gains are beneficial for both the firm [which uses such contracts], and for consumers, there should be no reason why antitrust authorities should intervene and forbid such contracts.
If the buyers were allowed to coordinate their purchase decisions, then they would not accept the deal and entry would occur.
b. Exclusionary effects: positive efficiencies from vertical mergers:
vertical mergers have positive ew effects, for instance, by getting rid of the double marginalisation problem, or by eliminating free-riding distortions.
But…. might vertical mergers be anti-competitive?…. no. vertical mergers are bring ew, because the upstream monopolist is able to extract all the profits (since there is no problem of double marginalisation). Hence, a vertical merger would not add market power to the monopolist
however….vertical mergers can result in foreclosure and anticomps, if the vertical merger allows a firm to solve a commitment problem, and keep its prices high.
Exclusionary effects of vertical mergers:
The upstream firm makes non negotiable offers to the downstream firms….In this case, a vertical merger could not increase the profit of the upstream firm. Therefore, a vertical merger would take place only if it entailed some efficiency gain.
conclusions
vertical restraints and vertical mergers have a number of efficiencies, which usually outweigh any anticomps, so they should be cleared.
Vertical restraints and vertical mergers are only anti-competitive if they involve firms endowed with significant market power. Accordingly, there is no need to monitor vertical restraints and mergers which involve firms with little market power….eg. a good proxy would be to exempt firms with market shares below, say, 20-30% (as in the new regime created in the EU, except that practices such as RPM are black-listed).
This leaves the problem of how to deal with vertical restraints and vertical mergers which involve firms with significant market power, and which have possible exclusionary effects. In these cases, one should balance possible efficiency effects v anticomps.
The analysis of vertical mergers [above], emphasised that:
(i) input foreclosure does not necessarily follow from them;
(ii) even if downstream rivals are foreclosed, final prices do not necessarily increase. This suggests a cma.ec two-step procedure for vertical mergers between firms with high market share threshold.:
a. it should be established whether the merger will likely lead to input foreclosure, that is, that input prices for independent downstream firms will increase (Gompetstors will be harmed). If so, the investigation should continue to the second step. If not, the merger should be cleared.
b. In the second step (if applicable), it should be established whether final consumer prices are likely to increase or not (Gompetstson will be harmed).
The same procedure should be followed for vertical restraints that might lead to foreclosure of rivals.
•Cases:
General EleGtrsG/Honeymell:
concerns a merger which has vertical aspects (as well as horizontal and conglomerate aspects).
ec received the notification of a project according to which General Electric (GE) would have taken over Honeywell. Both firms are based in the US, but their large size implies that the merger met the thresholds for being reviewed by the EC as well. The US Department of Justice approved the deal, but EC prohibited the merger.
Several product markets (all worldwide in geographic terms) are affected by the merger, mostly in the aerospace industry
there are three sectors: (1) jet engines, (2) aircraft systems (avionics and non-avionics), and (3) engine controls.
•The EC identifies four product markets associated with jet engine
.(1a) Jet engsnes for large GommerGsal asrGraft (roughly speaking, aircraft with more than 100 seats and that can travel long distances). In this market, where there are only two airframe manufacturers, Airbus and Boeing (each with roughly half of the market), there are five main active engine suppliers, GE, Rolls-Royce (RR), Pratt&Whitney (P&W), CFMI, which is a 50-50 joint- venture between GE and the French firm SNECMA, and IAE, a joint-venture between RR, P&W (each with a 32% share) and two other firms. Honeywell is not present in this market, and therefore the merger does not have a horizontal dimension.
(1b) Engsnes for regsonal jet asrGraft (aircraft with 30 to 100 seats, man– ufactured by Embraer, Bombardier, Fairchild Dornier and British Aerospace), which is further divided by the EC in engines for small regional aircraft, where Honeywell is not present, and in engines for large regional aircraft, where both Honeywell and GE operate. CFMI, RR and P&W are also active if one – unlike the EC – defines the market so as to include Airbus’ and Boeing’s small narrow- body planes, which are also used for transport over medium distances
(1c) Engsnes for Gorporate jet asrGraft (designed mainly for corporate ac- tivities, and therefore aimed at carrying a lower number of passengers; man- ufacturers are Cessna, Gulfstream, Raytheon, Bombardier and Dassault); GE, Honeywell, RR and P&W are all present in this market. Engines for large commercial and for regional aircraft are usually sold to two distinct categories of buyers: airframe manufacturers and end-users (that is, airlines or leasing companies). Indeed, the airframe manufacturers do not necessarily choose only one type of engine for any particular aeroplane: they can certify di erent engines and then leave the final choice to the end-users, which might have di erent preferences as for the engines to be fitted in the planes they buy, for instance, due to economies from using the same make of engine (called Gommonalsty benefits). Engines for corporate jet aircraft are usually chosen by airframe manufacturers, not by end-users.
(1d) MasntenanGe, repasr and overhaul (MRO) of engines, that is after- markets (services and spare parts).:; These services are provided by all the original engine manufacturers (such as GE, Honeywell, RR and P&W), by air- lines’ maintenance departments, and by independent service shops. These are very important activities (jet engines need freąuent service, maintenance and reviews), which account for a large part of the revenues of the engine manufac- turers.
Horizontal, conglomerate, vertical aspects of the merger:
this merger ‘s dimension:
a. a horizontal nature, as far as the market for large regional jet engines is concerned, where GE and Honeywell are competing.
b. a conglomerate nature, because in several product markets only one of the merging partners is present.
c. it has a vertical nature, because Honeywell and GE have an upstream-downstream relationship, in that the former produces engine controls used by the latter in the production of engines, but also because GE is an important buyer of aeroplanes through its leasing company GECAS, and in this sense it (indirectly) purchases Honeywell products. Indeed, the EC decision argues that GECAS, after the merger, would be able to tilt the upstream avionics and non-avionics product market in favour of Honeywell.
EC : GE enjoys, even before the merger, a position of dominance in large commercial aircraft and regional aircraft engines, and can strengthen it in the markets it dominates already, or extend it to the markets where Honeywell has a leading position.
EC believed that, after the merger, GE would be able to leverage its market power
The EC seems therefore to suggest that GE wants to increase the overall prices paid by buyers, while at the same time hurting its rivals, just by modifying the stream of revenues, that is by charging low prices on the main product, engines, and increasing more than proportionately prices in the after- markets (spare parts and services).
Still according to the EC, GE’s vertical integration in after-markets is also important, because GE has used its financial strength to invest ,for several years, into the aftermarket, through the purchase of repair shops all over the world.
This strategy applies not only to the servicing of GE’s own engines but also to the engines of its competitors which as a result end up deprived of the critical aftermarket revenues
Another factor contributing to GE’s dominance, according to the EC, is its vertical integration into aircraft purchasing, financing and leasing activities through its subsidiary GE Capital Aviation Services (GECAS). GECAS is the largest single purchaser of new aircraft, accounting for around 10% of these purchases. Apart from the major airlines, another important buyer is another leasing company, ILFC, whose fleet is around half GECAS’ fleet.
According to the EC, GECAS – that has a policy of buying only GE engines – has a strong influence in the marketplace
EC argues that a firm that buys 10% of aircraft, is able to manipulate aircraft manufacturers’ decisions so as to persuade them to buy GE engines (thus resulting in the foreclosure of rivals).
The markets involved in this merger are all markets where entry is difficult (both because of the sunk costs and the technological know-how reąuired), so whatever market power exists it will not be likely to be constrained by new entrants.
The other important element to be considered is the power of the buyers.
the EC claims that GE Capital’s financial assistance and the prospect of selling planes to GECAS play a big role in affecting buyers’ decisions, but it seems doubtful that Airbus and Boeing will not be able to exercise countervailing power. The EC decision is silent as to the reaction of buyers with respect to this merger
the EC argues that after the merger, the new firm will engage in bundling (several components will be sold only in a uniąue package, at a single price) or mixed bundling
Bundling and packaged deals , reduce prices and force competitors to exit
my opinion: even if bundling happens, this is not enough to prove that the merger will be anti-competitive.
Will the merger hurt consumers?
for bundling to win market shares and to hurt competitors, this must mean that some price reductions for buyers should follow
But although the effect of the merger is (presumably) to reduce buyer prices, the EC blocked it because it expected it to result in the exit of GE’s rivals, and a subseąuent price increase.
my opinion: to asume the exit of GE’s rivals, the ec should have proven[but did not]:
a. the high likelihood that ge’s rivals will exit.
b. even if rivals will indeed exit…. how soon? The operating life of an aeroplane is very long,
it would have been better if EC allowed the merger but reviewed the industry later so as to open an investigation for abuse of dominance as soon as GE/Honeywell had engaged in suspected monopolisation practices.
Ice-cream
In 1991, the Mars group lodged a complaint with ec, claiming that exclusive agreements linking retailers with the two leading firms, Langnese-Iglo (LI) and Schöller, hindered its sales in the German ice-cream market.
ec case conclusion: predation takes place where the incumbent uses aggressive market behaviour, to modify the expectations of the profitability of the prey….. In this mars case, predation fafects the lender’s evaluation that the firm they finance will be successful. As a result, the prey will have a lower ability to borrow and will be obliged to exit the industry, or to reduce the scale of its operations.
EC decided that indeed those agreements had infringed article 81 of the Treaty, and prohibited the two firms from using them.
The definition of the relevant market :
Although this is not an adp case, the definition of the relevant market is crucial, in order to evaluate whether the firms have enough map, and whether the proportion of outlets subject to exclusivity agreements is important enough.
As for the relevant product market:
only ‘impulse purchase icecream by an individual consumer’ is the relevant market here. not the crafted icecream, nor the industrial one.
a hypothetical monopolist would not find it profitable to raise prices in a significant and non-transitory way, unless it sold all three categories of ice-cream. The SSNIP test would unambiguously indicate that the relevant product market consists of industrial impulse ice-cream , craft-trade ice-cream and industrial scooping ice-cream
From the geographical point of view, the impulse ice-cream market should be local.
Market power, and the relative importance of exclusive agreements:
The extent to which a firm like Mars – an internationally renowned company with products (other than ice-cream) already established in Germany – finds considerable barriers to entry in this market, is overstated by the EC.
Nevertheless, the EC worries that exclusive agreements in this industry might foreclose entry do have some foundations.
Efficiency effects of the exclusive agreements:
my opinion is that, is not clear that exclusivity contracts would have any foreclosing effect
the final price paid by consumers is lower, and total industry output increases, under the vertical merger.
Predation, monopolisation, and other abusive practices
exclusionary practices are carried out by an incumbent , to deter entry or force the exit of rivals. in eu, is called adp. in usa, is called monopolisation
exclusionary behaviour is one of the most difficult to spot, as they are hard to tell from competitive actions that benefit consumers. For instance, suppose that following entry into an industry a dominant firm reduces its prices :
should this be considered an anticomp aimed at forcing the new entrant out of the industry (after which prices will be raised again, damaging consumers in the long-run), or is it instead just the a competitive response that will be beneficial to consumers?
•Predatory pricing: charging too low pricing.
where a dominant firm set low prices with an anticomp goal: forcing a rival out, or pre-empting a potential entrant. In these cases, low prices improve ew, only in the short-run, for the time predation lasts; once the prey has succumbed, the predator will increase its price. The final effect of predatory behaviour , thus, is to worsen ew, in the long-run, because it eliminates competition.
A large firm might drive a small competitor out of the market by waging a price war that gives losses to both. But the small competitor has limited resources (a ”small pocket“) and will therefore be unable to survive such losses for a long time.
however, today we know that this is hardly true. instead, predation can be fully explained only in a context of info asymmetry : the predator will try to use the imperfect knowledge of the entrant (or of the outside investors that finance it), to make them believe that the entrant would not make high profits. As a result, the entrant will exit, or its lenders will not be willing to fund.
Within this set of recent (game theoretic) predation models of imperfect information, there are three main types that can be identified:
(i) reputation models,
(ii) signaling models,
(iii) financial market models of ”deep pocket“ predation
(i) Reputation models
the weak incumbent’s decision to fight reinforces its reputation to be efficient, but involves the sacrifice of current profits in order to deter entry and earn higher future profits.
At the beginning of the game, the future is far enough and the trade-off is in favour of fighting, whereas at the end of the game there is less to be gained from deterring further entry (at the limit, in the last period there is no future gain at all), and the trade-off is in favour of accommodating.
(ii) Signaling models
Before taking its entry decisions, a potential entrant observes the price set by the incumbent when it is still a monopolist. If it was certain that the incumbent is weak, entry would be profitable. If it was certain that the incumbent is strong, entry would entail a loss. But the entrant cannot tell them apart. It thinks it will face a strong incumbent with some probability, but it can only revise this probability by observing the monopoly price of the incumbent
Predation for mergers: An extension of the signaling model, explains why predation might lower the price of taking over rivals…setting a too low price, signals to the entrant whether it should expect to make high or low profits after entry, and therefore whether it should be willing to sell out to (to merge with) the incumbent at a high or at a low price….here, the lower prices are not to deter entry, but to improve the terms at which the rival will accept to be taken over.
(iii) Predation in imperfect financial markets
in the deep pocket theory of predation, is that it does not explain why the prey has limited access to funding.
imperfect information on the side of the lenders: The bank cannot be sure that the money lent is used in an efficient way, thus they ask for assets as retained earnings/guarantee of payment. if there are not enough assets, credit may be denied even for profitable projects.
Conclusion
The analysis shows that by setting a low enough price (a large enough output) and pretending to be an efficient producer, an incumbent may deter entry. In the example above, this is possible whenever the high cost incumbent is not too inefficient,and the ex-ante probability that the entrant attaches to the incumbent being low cost, is high enough.