Lecture 16 Vertical, Complementary, and Conglomerate Mergers

1. Lecture 16Vertical, Complementary, and Conglomerate Mergers ECON 4100: Industrial Organization

2. Introduction • Conglomerates • Vertical Mergers • Complementary Mergers • The problem of double marginalization • Price discrimination

3. Conglomerates (diversification) • Exploit economies of scope (remember that these often apply only at the plant level: you want to relocate plants, reorganize things to exploit economies of scope) • To grow without dominating your product’s market: diversify (you will avoid the regulatory watchdogs) • To protect yourself from the demand decline for your product • Diversify to spread risk (demand for your product might be OK now, but we do not know about the future, just in case: diversify!)

4. Conglomerates (diversification) • Diversify to spread risk (demand for your product might be OK now, but we do not know about the future, just in case: diversify!) • But the shareholders do not need that diversification • They can diversify their own portfolio themselves! • This diversification logic is valid only for the manager

5. Vertical Mergers • Now consider very different types of mergers • between firms at different stages in the production chain • also applies to suppliers of complementary products • These mergers turn out, in general, to be beneficial for everyone.

6. Complementary Mergers • Take a simple example: • final production requires two inputs in fixed proportions • one unit of each input is needed to make one unit of output • input producers are monopolists • final product producer is a monopolist • demand for the final product is P = 140 - Q • marginal costs of upstream producers and final producer (other than for the two inputs) normalized to zero. • What is the effect of merger between the two upstream producers?

7. Complementary mergers (cont.) Supplier 1 Supplier 2 price v2 price v1 Final Producer price P Consumers

8. Complementary producers Consider the profit of the final producer: this is pf = (P - v1 - v2)Q = (140 - v1 - v2 - Q)Q Solve this for Q Maximize this with respect to Q - (v1 + v2) pf/Q = 140 - 2Q = 0 => Q = 70 - (v1 + v2)/2 This gives us the demand for each input Q1 = Q2 = 70 - (v1 + v2)/2 So the profit of supplier 1 is then: p1 = v1Q1 = v1(70 - v1/2 - v2/2) Maximize this with respect to v1

9. Complementary producers (cont.) The price charged by each supplier is a function of the other supplier’s price p1 = v1Q1 = v1(70 - v1/2 - v2/2) We need to solve these two pricing equations Solve this for v1 Maximize this with respect to v1 p1/v1 = 70 - v1- v2/2 = 0 v1 = 70 - v2/2 v2 We can do exactly the same for v2 140 R1 v2 = 70 - v1/2 v1 = 70 - (70 - v1/2)/2 = 35 + v1/4 70 so 3v1/4 = 35 so v1 = $46.67 46.67 R2 and v2 = $46.67 v1 70 140 46.67

10. Complementary products (cont.) Recall that Q = Q1 = Q2 = 70 - (v1 + v2)/2 so Q = Q1 = Q2 = 23.33 units The final product price is P = 140 - Q = $116.67 Profits of the three firms are then: supplier 1 and supplier 2: p1 = p2 = 46.67 x 23.33 = $1,088.81 final producer: pf = (116.67 - 46.67 - 46.67) x 23.33= $544.29

11. Complementary products (cont) Now suppose that the two suppliers merge Supplier 1 Supplier 2 23.33 units @ $46.67 each 23.33 units @ $46.67 each Final Producer 23.33 units @ $116.67 each Consumers

12. Complementary mergers (cont.) Supplier 1 Supplier 2 price v The merger allows the two firms to coordinate their prices Final Producer price P Consumers

13. Complementary merger (cont.) Consider the profit of the final producer: this is pf = (P - v)Q = (140 - v - Q)Q Solve this for Q Maximize this with respect to Q - v pf/Q = 140 - 2Q = 0 => Q = 70 - v/2 This gives us the demand for each input Q1 = Q2 = Qm = 70 - v/2 So the profit of the merged supplier is: pm = vQm = v(70 - v/2) Maximize this with respect to v

14. Complementary merger (cont.) This is the cost of the combined input so the merger has reduced costs to the final producer pm = vQm = v(70 - v/2) The merger has reduced the final product price: consumers gain Differentiate with respect to v pm/v = 70 - v = 0 so v = $70 Recall that Qm = Q = 70 - v/2 so Qm = Q = 35 units This is greater than the combined pre-merger profit This gives the final product price P = 140 - Q = $105 What about profits? For the merged upstream firm: This is greater than the pre-merger profit pm = vQm = 70 x 35 = $2,480 For the final producer: pf = (105 - 70) x 35 = $1,225

15. Complementary mergers (cont.) • A merger of complementary producers has • increased profits of the merged firms • increased profit of the final producer • reduced the price charged to consumers Everybody gains from this merger: a Pareto improvement! Why? • This merger corrects a market failure • prior to the merger the upstream suppliers do not take full account of their interdependence • reduction in price by one of them reduces downstream costs, increases downstream output and benefits the other upstream firm • but this is an externality and so is ignored • Merger internalizes the externality

16. Vertical Mergers • The same kinds of result arise when we consider vertical mergers: mergers of upstream and downstream firms (for example, production and retailing can be considered complementray in the production of the retailed product!) • If the merging firms have market power • lack of co-ordination in their independent decisions • double marginalization • merger can lead to a general improvement

17. Vertical Mergers • We can illustrate this with a simple model • one upstream and one downstream monopolist (manufacturer and retailer for simplicity) • upstream firm has marginal costs $20 • sells product to the retailer at price r per unit • retailer has no other costs: one unit of input gives one unit of output • retail demand is P = 140 - Q

18. Vertical merger (cont.) Marginal costs $20 Manufacturer wholesale price r Price P Consumer Demand: P = 140 - Q

19. 140 - r 2 Vertical merger (cont.) • Consider the retailer’s decision • identify profit-maximizing output • set the profit maximizing price marginal revenue downstream is MR = 140 - 2Q marginal cost is r Price equate MC = MR to give the quantity Q = (140 - r)/2 140 Demand identify the price from the demand curve: P = 140 - Q = (140 + r)/2 (140+r)/2 profit to the retailer is (P - r)Q which is pD = (140 - r)2/4 profit to the manufacturer is (r-c)Q which is pM = (r - c)(140 - r)/2 r MC MR Quantity 70 140

20. 140 - r1 140 - r 2 2 Vertical merger (cont.) suppose the manufacturer sets a different price r1 Price then the downstream firm’s output choice changes to the output Q1 = (140 - r1)/2 140 Demand and so on for other input prices r1 demand for the manufacturer’s output is just the downstream marginal revenue curve r MC Upstream demand MR Quantity 70 140

21. Vertical merger (cont.) the manufacturer’s marginal cost is $20 upstream demand is Q = (140 - r)/2 which is r = 140 - 2Q Price upstream marginal revenue is, therefore, MRu = 140 - 4Q 140 110 equate MRu = MC: 140 - 4Q = 20 Demand and the input price is $80 so Q* = 30 80 while the consumer price is $110 Upstream demand the manufacturer’s profit is $1800 20 the retailer’s profit is $900 MC MRu MR Quantity 35 70 140 30

22. Vertical merger (cont.) • Now suppose that the retailer and manufacturer merge • manufacturer takes over the retail outlet • retailer is now a downstream division of an integrated firm • the integrated firm aims to maximize total profit • Suppose the upstream division sets an internal (transfer) price of r for its product • Suppose that consumer demand is P = P(Q) • Total profit is: • upstream division: (r - c)Q • downstream division: (P(Q) - r)Q • aggregate profit: (P(Q) - c)Q The internal transfer price nets out of the profit calculations • Back to the example

23. Vertical merger (cont.) This merger has benefited consumers This merger has benefited the two firms the integrated demand is P(Q) = 140 - Q marginal revenue is MR = 140 - 2Q Price marginal cost is $20 140 so the profit-maximizing output requires that 140 - 2Q = 20 so Q* = 60 Demand so the retail price is P = $80 80 aggregate profit of the integrated firm is (80 - 20)x60 = $3,600 20 MC MR Quantity 60 70 140

24. Vertical merger (cont.) • Integration increases profits and consumer surplus • Why? • the firms have some degree of market power • so they price above marginal cost • so integration corrects a market failure: double marginalization • What if manufacture were competitive? • retailer plays off manufacturers against each other • so obtains input at marginal cost • gets the integrated profit without integration

25. Vertical merger (cont.) • Why worry about vertical integration? • two possible reasons • price discrimination • vertical foreclosure

26. Price discrimination • Upstream firm selling to two downstream markets • different demands in the two markets the seller wants to price discriminate between these markets v1 v2 set v1 < v2 but suppose that buyers can arbitrage va Market 1 Market 2 then buyer 2 offers to buy from buyer 1 at a price va such that v1 < va < v2 P P  arbitrage prevents price discrimination  if the seller integrates into market 1 arbitrage is prevented D1 D2 Q Q

27. Price discrimination • With which downstream market would you want to merge first??? • The one with most elastic demand of course!

28. Vertical foreclosure • Vertically integrated firm refuses to supply other firms • so integration can eliminate competitors suppose that the seller is supplying three firms with an essential input the seller integrates with one buyer if the seller refuses to supply the other buyers they are driven out of business is this a sensible thing to do?

29. Vertical foreclosure The integrated firm will not source on the independent market Suppose that there are some integrated firms and some independent upstream and downstream producers Profit of an integrated firm is: The integrated firm will not sell on the independent market pI = (PD - cU - cD)qDi Profit of an independent upstream firm is: pU = (PU - cU)qUn Profit of an independent downstream firm is: pD = (PD - PU - cD)qDn

30. Vertical foreclosure For the independent upstream firms to survive requires PU - cU > 0 The downstream unit of an integrated firm obtains input at cost cU Buying from an independent firm costs PU > cU so the downstream divisions will not source externally Now suppose that an upstream division of an integrated firm is selling to independent downstream firms it earns PU - cU on each unit sold But this is true: so diverting output from the external market increases profits Profit from selling externally  Divert one unit to its downstream division: this leaves the downstream price unchanged: Profit from selling internally it earns PD - cU - cD on this unit diverted PD - PU - cD > 0 for independent downstream firms to survive PD - cU - cD > PU - cU requires: PD - PU - cD > 0 so the upstream divisions will not sell externally

31. Vertical foreclosure (cont.) • Foreclosure happens • but is not necessarily harmful to consumers • reduces number of buyers in the upstream market • increases prices charged by independent sellers to non-integrated downstream firms • but integrated downstream divisions obtain inputs at cost, making them a fiercer competitor in the downstream market • puts pressure on non-integrated downstream firms • provided there are “enough” independent upstream firms the anti-competitive effects of foreclosure will be offset by the cost advantages of vertical integration (the avoiding of the double marginalization problem)

32. Vertical foreclosure (cont.) • Foreclosure happens • Remember that foreclosure affects both the downstream market and the upstream one (the other upstream ones have no distributor for their product, the alternative distributor do not get to buy the inputs) • E.g. imagine that a car manufacturer merged with some steering wheel manufacturer. The car company would not buy form the alternative suppliers! • Also the steering wheel section of the firm does not sell to other car companies!

33. NEXT • Vertical relations and vertical restraints