Competition and the Vertical Organization of Industries

University Of Colorado At Boulder, Boulder CO

Investigators

Abstract

Models of vertical integration and disintegration are constructed in order to understand how competition affects and is affected by the vertical organization of industries. The main innovation is to recognize that the vertical structure of a firm affects not only its own behavior but also the behavior of its rivals in the horizontal competition. Part I of the project studies competition and vertical integration. It starts with the realization that a firm's vertical integration changes its downstream rivals' incentive in choosing input suppliers. In particular, the rivals may be willing to purchase input at a higher price from the integrated firm. This insight leads to the observation that some important results in the current theory of vertical foreclosure are incorrect. An equilibrium model of vertical integration will then be developed that takes into account the strategic behavior of both the integrated firm and its rivals. It is expected that this model will provide a framework in which the foreclosure (collusive) effect and the efficiency effect of vertical mergers can be measured and compared. A linear-demand example is analyzed where it is found that a vertical merger will have the effect of market foreclosure if and only if it also has efficiency gains; and that situations can be identified where the vertical merger increases or decreases consumer welfare. These and other results will be explored in the general setting of the model. Part 2 of the project studies a model of vertical disintegration. This model has its roots in a classic paper by Stigler, who envisioned that as industries grew, the upstream divisions of some initially integrated firms would be disintegrated to take advantage of specialization and economies of scale. What is not clear in Stigler's theory is why a specialized firm should be preferred to a specialized division of an integrated firm in exploring the economies of scale and supplying the other firms. The proposed model aims to offer an answer to this by considering horizontal competition. The key insight is that the downstream rivals, for strategic reasons, may choose not to purchase from the integrated firm unless its price is sufficiently lower than those offered by unintegrated upstream producers. This insight is obtained through the study of a lineardemand example, and its full implications will be explored in the model. An equilibrium theory of vertical disintegration is expected to emerge through this analysis. Part 3 of this project aims to unify the models of vertical integration and disintegration in a general theory of competition and vertical organization. A crucial distinction will be made about whether the integrated firm's cost advantage is exogenous or endogenous. This difference will explain why the integrated firm's downstream rivals can have two opposite behaviors in the input market, and will hence explain the different equilibrium outcomes of vertical organization. This theory will also incorporate the current theory of vertical foreclosure by clarifying the additional assumptions that are needed. The connections between this theory and other theories of firms and markets will be established. All of the research envisioned above involves the construction and theoretical analysis of mathematical models based on observed features of firms and industries and on non-cooperative game theory.