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What are the arguments for and against vertical integration?
A vertical structure consists of an upstream firm such as a manufacturer of an intermediate good, and a downstream firm such as a wholesaler or a retailer. The down stream firm may also be a manufacturer or service provider using the intermediate good as an input. An upstream firm is said to be vertically integrated if it controls (directly or indirectly) all the decisions made by the vertical structure. The vertically integrated profit therefore refers to the maximum aggregate profit of the vertical structure (manufacturer's plus retailer's). There are many cases where the firms (and possibly the consumers) will benefit from vertical integration.
One such example is where the problem of double marginalisation exists. Consider the case where both the upstream and downstream firms have monopoly power. If vertical integration exists, the final price charged to the consumer would be pm and the quantity supplied (qm) would be determined by the demand function D (.).
So, qm = D (pm)
Pm would be chosen to maximise (p ¨C c)D(p), where c represents the cost of production. In the decentralised structure the manufacturer will provide the intermediate good to the retailer at a price pw, which he will choose to maximise his profits as a monopolist. The retailer will then have a marginal cost of pw, so the final price, p, will be greater than the vertically integrated price of pm (assuming pw c). Because the retailer does not consider the manufacturers marginal profit, there are two successive mark-ups, causing the decentralised price to be greater than the vertically integrated one.
To examine this in greater detail, consider a case where there is a demand function of D(p) = 1 ¨C p, and c1. Let ¡Çm and ¡Çr denote the manufacturer's and retailer's profits respectively. For simplicity we will assume that the retailer incurs zero costs other than the price of the intermediate good. For the non-integrated industry, the retailer will want to maximise
(p ¨C pw)(1 ¨C p)
which will give
p = 1 + pw
Using the demand function, the quantity to be provided will then be
q = 1 ¨C pw
Hence, the retailer makes a profit of
¡Çr = ((1 ¨C pw)/)
Now, consider the manufacturer's situation. He will want to maximise
(pw ¨C c) ((1 ¨C pw)/)
Which will give
Pw = 1 + c
Thus giving him a profit of
¡Çm = (1 ¨C c)
8
Therefore, the total profit of the decentralised industry is (1 ¨C c)
16
and the final price is p = + c .
4
If, however vertical integration exists, the vertical structure will maximise
(p ¨C c) (1 ¨C p)
this gives a final price of
p = 1 + c
and a vertically integrated profit of
¡Çintegrated = (1 ¨C c)
4
¡Çdecentralised
In this example, the total profit is higher for the vertically integrated structure and the price to the consumer is lower that it would be without integration. The quantity provided is also lower without integration. Therefore vertical integration is clearly beneficial in such cases where double marginalisation is problem. However, this problem only arises where both the firms are monopolists. If either of the firms is competitive and therefore prices at marginal cost, there is no price distortion and so the total profit will not be increased by integration.
Vertical integration is, however, not always necessary for the vertically integrated profit to be realised. One way a manufacturer can control this in a decentralised industry is by imposing a franchise fee. This is effectively a two part tariff charged to the retailer. i.e. the retailer's cost will be A + pwq. It is clear that the manufacturer can set pw = c, therefore setting the retailer's marginal cost equal to that of the integrated structure. The retailer will set his final price by maximising
(p ¨C c)D(p) ¨C A,
which then gives p = pm. His profit is then equal to the vertically integrated profit minus A. In this way the manufacturer is selling the vertical structure to the retailer as a price A, thus making the retailer the residual claimant.
This form of vertical restraint however, has some disadvantages. Firstly, it is possible that the retailer will be risk-averse and his retail costs or final demand may be random. In this case the retailer will bear too much risk and require the retailer to lower the franchise fee and raise pw to compensate for this risk. This then means that the final price, p, will be higher than that of the vertically integrated structure. Another drawback to the two-part system is that the retailer may possess information about retail costs or final demand, after the contract has been signed. As this information will not be then passed to the manufacturer, the franchise fee will not be tailored to appropriate the retailer's profit.
Another way the manufacturer could realise the vertically integrated price would be to adopt a Resale-price maintenance restriction. The retailer would then be forced to charge at a price no higher than pm. The manufacturer could then charge pw=pm and so gain the integrated profit. Similarly, the manufacturer can impose a quantity constraint, where q qm . These restrictions again have drawbacks, as it would be very risky for the retailer if his final demand and retail costs were not certain.
The welfare considerations to this situation are very clear. Under vertical integration (or even with vertical restraints) the firms make a greater profit than they would under a decentralised system, and consumers benefit from a lower price. Therefore, welfare is unambiguously increased by vertical integration.
Another situation where vertical integration would be beneficial is where there is a downstream moral hazard. This is where a retailer may be able to provide pre-sale services which an affect the final demand for the good, but there is not sufficient incentive for him to provide it. Examples of such services include advertising, test drives, free delivery, free alterations etc. As these may increase the demand, it is beneficial to the manufacturer if these services are supplied. However, as the amount of services cannot be accurately measured, it is not possible to specify the amount of promotional services to be provided, in the contract. Therefore the manufacturer must create and incentive for the retailer to provide the services.
We can define the amount of promotional services by a real number s. The consumer's demand will therefore be a function of both price and service.
i.e. q = D(p,s).
Assuming that the cost of services is born by only the retailer, let §¶(s) denote the cost of providing service s. Therefore, the manufacture will maximise
(pw ¨C c)D(p,s)
and the retailer will maximise
(p ¨C pw ¨C §¶(s))D(p,s)
There again exists a double marginalisation problem, as the manufacturer will charge pw c. Because the retailer does not take into consideration the increase in the manufacturer's profit due to an increase in services, at any given price the retailer will provide too few services and so cause demand to decrease.
Vertical integration would remove this externality, as the integrated firm would them aim to maximise the total profit of the structure. Therefore, integration would not only increase the profit of the structure, it would also mean that more services would be provided, which would benefit consumers.
The manufacturer may choose to impose vertical restraints to increase the amount of service provided by the retailer. One way of doing this would be to impose a two-part tariff as mentioned before, thus making the retailer the residual claimant and so will receive any marginal profits. This gives him an incentive to provide more services, benefiting both firms.
Unlike the previous example, the service externality cannot be removed by RMP. The manufacturer can set the price p = pm, however the retailer still has no reason to provide more services.
Another problem similar to the downstream moral hazard is if the manufacturer is able to provide service which will increase demand, such as branding, quality etc. If there is vertical integration, the profits for both firms will again increase, as will the welfare for consumers as services increase. However, without integration, the problem exists of providing an incentive for the manufacturer to provide the services. One way to do this would be to introduce a third firm which would make non-negative profit and would buy the intermediate good from the manufacturer at a linear price, and sell it to the retailer using a two-part tariff. This would make both the upstream and downstream firms residual claimants and therefore provide and incentive to provide services to increase their profits.
This is again a case where both firms and consumers would benefit from vertical integration.
A further example of where vertical integration would be beneficial is where the downstream firm uses inputs from more than one manufacturer. Consider a case where the retailer uses inputs from manufacturers where one is a monopolist and the other is a competitive firm (i.e. prices at marginal cost). Thus the relative price of the inputs for the downstream unit exceeds their true relative price, and so the downstream unit will substitute towards the second input. The upstream monopolist can then integrate with the downstream firm to realise the vertically integrated profit.
This can again be done using various vertical restraints. The two-part tariff can again b used, making the downstream unit the residual claimant. Another method which can be used is a tie-in and the RPM. This is a contract which binds the downstream unit into buy the second intermediate good from the monopolist. This however, can have drawbacks as it is often not practical for the monopolist firm to be able to provide the second input as it is hard for it to be able to cover so many areas. Therefore, again, vertical integration would be a useful tool to increase the profits to the firms and keep the price lower than if the structure was decentralised.
The welfare analysis of vertical integration can sometimes be a little ambiguous. Consider a case where there is a monopolist manufacturer and many retailers. Looking at the first order conditions for the retailer when integrated and when decentralised, the integrated retailer considers the marginal revenue from any increase in demand. However, the competitive retailer is more concerned with the marginal surplus, which includes the total increase in demand. From this, we can say that it is possible that more services will be provided by the competitive retailer at a given wholesale price. However, the vertically integrated structure theoretically will charge a lower wholesale price.
Another problem which firms may face is the horizontal externality. This is where there are many retailers, and they are able to provide the consumers with pre-sale information. Examples of this may be free samples, test drives, literature, demonstrations etc. Any firm who incurs the cost of providing this information must then raise its price to compensate. This leads to the problem where consumers will gain the information from one firm and then buy the product from another firm which is cheaper due to not providing the information. In this way firms are able to free-ride on one another, which leads to the public good being undersupplied. Vertical integration may resolve part of his problem as it then provides the retailer with a monopoly position and eliminates competition. A manufacturer may not want to do this however as it may result in a loss of total sales. Although integration will enhance consumer welfare due to more information being provided, the elimination of retail competition may result in a significant increase in the final price. Other forms of vertical control may be used in this case such as RPM. With a set retail price, consumers are more likely to buy from the retailer providing the information as they will not find a better price anywhere else.
One way in which vertical integration may be damaging to welfare is if retailers pressure a manufacturer to impose vertical restraints to eliminate competition. For example, if there are several retailers, they are likely to engage in competition and eventually charge at marginal cost. If, however, the manufacturer imposes RPM where p marginal cost, they are legally bound to charge this that price. Therefore, they vertical restraint is used to reduce competition and the retailers will be able to make higher profits. This is of course damaging to the consumers' welfare as they are charged a higher price.
Another disadvantage to vertical integration is if the retailer engages in an exclusive dealing contract with the manufacturer, i.e. he cannot sell a brand which competes with the manufacturer's product. This is detrimental to consumer welfare as there is a reduction in choice. However, it may increase the efficiency of the vertical structure in the same way that a manufacturer giving a retailer exclusive territory would. Exclusive dealing would provide the manufacturer with an incentive to provide promotional services. These types of contracts however, can also act as a barrier to entry for other manufacturers, therefore keeping the competition in the upstream market soft. RPM can also be used to maintain collusion between manufacturers as then wholesale price cuts are less effective.
As shown above, there are many externalities which arise within a vertical structure which clearly benefit from vertical integration. Integration can be harmful if used to reduce competition as it raises prices and decreases consumer welfare. However, it can be a useful tool in resolving problems such as double marginalisation and the downstream moral hazard.
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