Vertical Integration and the Risk of Information Leakage

accepted by antitrust practitioners: vertical mergers were harmful to competition, for vertically integrated firms have incentives to raise their non-integrated downstream rivals’ costs to soften competition. This view was challenged by the Chicago school authors in the 1970s on the ground that integrated firms cannot leverage market power from the upstream market (input market) to the downstream one (final product market). The last twenty years have witnessed the development of formal analysis of the subject. A substantial part of the literature has built around a common framework, introduced by the seminal paper of Ordover, Saloner and Salop (1990). This rich framework explicitly accounts for (i) the endogenous incentives to merge, (ii) the possibility for an unintegrated competitor to counter a merger, (iii) competition on the input market. Within this setting, even though integrated firms have incentives to raise their non-integrated rivals’ costs, this does not annihilate the competitive pressure on the input market; the literature has further enriched this setting to find conditions under which vertical integration may harm, or not, competition. Jérôme Pouyet and his co-authors have further developed this common framework by considering more elaborate market structures. The starting point of their analysis is that various industries are characterized by the presence of several integrated firms competing on an input market to supply unintegrated downstream competitors. For instance, in the mobile telephony market, Mobile Virtual Network Operators do not have a spectrum license or a mobile network, and must purchase a wholesale mobile service from the Mobile Network Operators. These market structures may also emerge endogenously: following two consecutive vertical mergers, the digital maps market is now supplied by a duopoly of integrated firms. Their main result shows that the competition between integrated firms on the upstream market to supply unintegrated downstream rivals may be less intense than expected. The intuition may be explained as follows: competition will develop on the upstream market if each integrated firm has an incentive to set its price under the price of its vertically integrated rival, say if vertically integrated firms “undercut” each others. An integrated firm faces the following trade-off when deciding whether to undercut. Undercutting yields additional upstream profits. However, it makes the integrated rival more aggressive on the downstream market, for a firm which supplies the upstream market tends to be a soft downstream competitor in order to protect its upstream revenues; this is the softening effect. When the latter effect is strong enough, the incentives to undercut vanish, and an integrated firm may not want to compete fiercely with its integrated rival on the upstream market. Several factors are shown to have an important impact on this tradeoff: product differentiation on the downstream market; cost differentials between integrated and unintegrated competitors, and the composition of the market structure. These factors affect, sometimes in a complex way, the trade-off between the softening effect and the upstream profits and, therefore, the competitive analysis of vertical mergers. Hence, vertical integration may harm welfare when the input market ends up being supplied by integrated firms only. The analysis also unveils that the assessment of the competitive effect of vertical integration must account for the characteristics of both the upstream and the downstream markets: single-market analyses of the vertically-related markets do not allow analyzing the integrated firms’ incentives to supply or not the input market.