Benefits: Vertical mergers or vertical integration may occur because there is some efficiency gain associated with transforming an arms-length contractual relationship between a buyer and a seller into that of employee-employer, or more generally into a single profit-maximizing entity.

Question first posed by Coase in 1937. Coase argued that a firm exists because the employer-employee relationship economizes on the transaction costs of performing many discrete activities. In other words, if the many day-to-day activities of firms had to be negotiated as separate discrete arms-length contracts, the transaction costs of negotiating these contracts would be higher than under the command system of employer-employee relationships.

By the same token there are diseconomies of integration that occur because the hierarchical structure required to coordinate the activities of large firms. Become slow to innovate and change, excessively conservative in R&D, product design, etc., decision by committee….

Question: Why do arguments for vertical integration based on technological economies, such as physical proximity, ultimately fail?

Another benefit of vertical merger/integration is elimination of the inefficiency of successive monopoly. Specifically, if there is a buyer and a seller, each of whom have market power, then joint surplus is generally larger if they merge, than if the seller charges a monopoly input price to the buyer, who then charges a monopoly final good price to consumers. Thus having one rather than successive monopolies increases joint surplus. [Demonstrate this result for a fixed-proportions case…]

Costs: A key cost to vertical merger/integration is foreclosure. If a producer of final goods vertically integrates with an input supplier, the final goods producer can then deny other similar final goods producers access to the inputs. Ordover, Saloner, and Salop developed a model in which vertical merger has anticompetitive effects by raising rivals' costs. Normally, if a buyer and a seller merge, the decline in input market demand just offsets the decline in input market supply, and so equilibrium input price does not change, and input market quantity declines since now the merged firm transfers input internally. But if the merger allows the remaining input suppliers to collude, then a monopolistic market input price may result, which raises the cost of the other final goods producers.

Vertical integration may also help facilitate collusion among "upstream" manufacturers by eliminating a retailer that might otherwise induce rivalry among manufacturers desiring access to that retailer.

What if you have an "upstream" monopolist that acquires a set of otherwise competitive "downstream" retailers. Can the monopolist's profits be increased by such a merger?

1. Fixed Proportions Case: No, for the same reason that joint surplus can be raised by elimination of successive monopoly. In this case all monopoly profits are extracted at one stage of production.
2. Variable Proportions Case: Yes, because now the integrated monopolist can set an internal transfer price for the internal input at its marginal cost, yielding an efficient input mix, whereas absent vertical integration it must charge a monopoly price for the input, which induces an inefficient substitution away from that input (a substitution that does not reflect the true "resource cost" or marginal cost of the input).

Note: We have identified several situations in which vertical merger/integration can enhance the profit of a firm with pre-existing market power. Thus one can argue that the fundamental problem is still a horizontal one-the market power that exists prior to vertical merger/integration. More interesting perhaps are cases of vertical restrictions….

Vertical Restrictions: Contractual restrictions between an upstream and a downstream firm. Include resale price maintenance, territorial restrictions, exclusive dealing, and tying.

• What is resale price maintenance (RPM)? Is there any potential efficiency enhancement from RPM? What is the potential anticompetitive effect?
• What are territorial restrictions/exclusive territories? Is there a potential efficiency-enhancing reason for this restriction? [intra-brand free riding on dealer services] What is the potential anti-competitive effect?
• What is exclusive dealing? Is there a potential efficiency-enhancing reason for exclusive dealing? [inter-brand rivalry may undermine provision of special dealer services] What is the potential anti-competitive effect?
• What is tying? Is there a potential efficiency-enhancing reason for tying? [protect input quality when retailers have an incentive to free-ride on system-wide reputation] What are the potential anti-competitive effects?