Appendix B: Is Vertical Integration a Problem?
Natural Monopoly and Vertical Integration
As mentioned above, particularly in network industries, the owner of the natural monopoly component is often vertically integrated into upstream or downstream markets. Ergas (1995) notes:
"Public utilities have generally operated on a highly vertically integrated basis. Services have typically been sold to final consumers, with intermediaries playing little or no role in the supply chain. The refusal to sell to intermediaries has excluded or in other ways inhibited competitors from even those parts of these industries which are not inherently natural monopolies: for example, long distance service in telecommunications, or generation in the electricity industry."[105]
A significant amount of recent research has explored the question of the incentives of a monopolist to vertically integrate into and to foreclose a related market[106]. Simple theory suggests that if the related market is perfectly competitive and operates with 'fixed proportions', the monopolist cannot increase his/her profits by vertically integrating into the related market and foreclosing competition. The monopolist can extract whatever monopoly rents are available in that market by raising the price of access to the facility to the profit-maximising point. "There is only one monopoly profit to be earned in a chain of production."[107]
There are, however, several reasons why a monopolist might want to vertically integrate into a related market:
- To escape from regulatory restrictions or to preserve cross-subsidies required by regulatory restrictions.[108,109]
- To take advantage of vertical economies of scale and scope, reduce transactions costs or internalise network spillover effects.[110,111]
- To eliminate 'double marginalisation'. This arises when the downstream market is imperfectly competitive. The upstream monopolist (using ordinary linear pricing) charges a price in excess of marginal cost. The downstream firm does not take into account the addition to the monopolist's profit when making pricing, promotional and technological decisions and therefore "tends to make decisions that lead to too low a consumption of the intermediate good. The problem is that the downstream firm's cost for the good differs from the vertical structure's. The aggregate profit is then lower than the vertically integrated one, which gives the monopolist an incentive to impose vertical restraints that eliminate this externality."[112] Welfare is unambiguously increased by the elimination of the double marginalisation.
- To eliminate the inefficiencies from 'variable proportions'. This occurs when the downstream market is perfectly competitive and uses the monopolised input and other inputs in variable proportions. "The basic insight is clear. The price set by a monopoly manufacturer leads downstream fabricators to substitute away from the monopoly input toward the other inputs which are competitively supplied. The resulting efficiency loss in downstream production can be converted into profit for the manufacturer when it integrates into the fabrication stage and expands usage of its input to the efficient level." Does vertical integration to address this problem increase or decrease welfare? "The loss from inefficient production is eliminated and captured by the manufacturer in the form of profits ... However the integrated manufacturer may increase the retail price of the fabricated product and thereby reduce consumer welfare".[113] The effect on overall welfare is ambiguous.
- To price discriminate in the downstream market. As is well known, where a monopolist sells into two downstream markets with different elasticities, the monopolist can increase its profits by charging a different price in each market. In particular, the monopolist would like to charge a higher price in the market with the less elastic demand. If the monopolist cannot prevent resale of the monopolist's product, such a strategy is not feasible. New entrants could purchase from the downstream firms in the elastic market and sell to the downstream firms in the inelastic market. By vertically-integrating into the downstream elastic market the monopolist can prevent this resale and charge a single, higher price in the inelastic market. Does this vertical integration increase or decrease welfare? "No clear policy conclusions can be drawn from this analysis. Third-degree price discrimination may increase or decrease total welfare depending on the nature of the derived demands of the downstream industries."[114]
- As a result of non-profit maximising goals of the incumbent management, such as the desire for a 'quiet life' perhaps arising from relatively weak oversight by owners.[115]
- For a variety of other reasons, as in the models of Tirole (1988) ('retail competition as an incentive device' and 'long-term contracts as a barrier to entry') and Hart and Tirole (1990).[116] These models have the property that vertical integration and market foreclosure reduces overall welfare.
It is clear from this list that the welfare consequences of vertical integration will depend upon the motivation for vertical integration. Integration to take advantage of vertical economies will, other things equal, improve welfare, whereas as integration with the intention of market foreclosure may, in some circumstances, reduce welfare. Tirole (1988) summarises the position as follows:
"These ... examples show that vertical integration or vertical restraints need not be detrimental to welfare, even when they are meant to increase monopoly profit. In such circumstances, the issue is the existence of monopoly power per se, not its by-products (vertical integration or vertical restraints). [However] ... vertical restraints may be privately desirable and at the same time socially undesirable. One should be cautious when assessing the effects of such restraints, but unqualified hostility toward vertical restraints is inappropriate."[117]
Why Introduce Competition In the Related Market?
Other things equal, competition can be expected to enhance productive efficiency as increasing the number of firms in the industry enhances the variety of experimental innovations that firms undertake and increases the opportunities for firms to learn from each other. In addition performance comparisons permit owners to identify substandard performance and reward performance on the basis of inter-firm comparisons. These efficiencies also extend to the incumbent monopolist.
The extent of the allocative efficiencies depends upon the regulated price for access. At the least the regulated price for access can be set so as to merely prevent the vertically integrated incumbent from foreclosing the related market.[118] If the incumbent's final prices are unregulated, this will permit the incumbent to continue to earn monopoly rents on the natural monopoly segment of the network. If the regulated price can be set efficiently (at SRMC or some substitute) competition may drive the final product prices down to the (second best) optimal prices.
Lyon and Hackett (1993), discussing open access policies in gas pipelines list several resulting advantages: "Greater upstream competition has several beneficial effects. Perhaps the most important is that allocative efficiency is enhanced as market prices gradually supplant regulated prices. For example, open access in natural gas alleviated persistent shortages by eliminating long-term contracts with formula-driven prices exceeding market-clearing levels. Greater upstream productive efficiency should also follow from open access policy; for example, independent electric power producers often bid below the costs a regulated utility would incur if it constructed its own new capacity. In addition, removal of rate-of-return regulation allows for a reduction in the resource costs of regulatory oversight. These savings include reduced regulatory personnel, less use of lawyers and expert witnesses in regulatory proceedings, and reduced use of court time in the appeals process. Enhanced upstream competition may also produce spillover efficiencies in related markets. For example, entry into long-distance telecommunications, made possible by open access policy, undermined the traditional cross-subsidy from long-distance to local service. Finally, the presence of a verifiable market price reduces the information-gathering costs for those services that still must be regulated."
As mentioned above, to this list we might add potential benefits to the owners of the incumbent monopolist. "Entry may provide benefits to the owners of the incumbent firm by allowing some measure of 'yardstick competition' . . . In a more competitive market (assuming that firms can be prevented from colluding) owners can more readily compare performance across firms. This allows them to discriminate between, say, low profits due to industry-wide demand shocks and low profits due to managerial slack or to rent-sharing between managers and workers. As a result, owners can better structure the incentives managers face, securing a closer alignment between managerial actions and public objectives."[119]
"Second . . . if firms are viewed as taking bets on particular ways of doing things, having a greater number of firms in a market will, other things equal, accelerate the rate at which the most efficient approaches are discovered by managers, owners and regulators. To the extent to which there are spill-over effects (the firms in an industry can learn from each other, for example, through the yardstick effects of benchmarking) learning will increase efficiency not only in the innovating firm but also across the firm populations as a whole. This mechanism . . . can be referred to as increasing 'sampling efficiency'."[120]
"Third, increased product market competition will alter the process by which inefficient firms are 'weeded out' and efficient firms are rewarded. The presumption here is that firms are indeed asymmetric, and that superior performance cannot be costlessly imitated. Stronger product market competition is then presumed to result in the more rapid and complete sorting of firms into distinct performance classes, with the less productive firms being forced to exit the market. The most natural route though which this Darwinian process occurs is the reduction in price-cost margins brought by increased competition, since this will make it more difficult for inefficient firms to survive. At the same time, regulators, now better able to compare performance, are not likely to continue protecting inefficient firms, while potential investors and employees, mindful of the costs of poor performance, will be less willing to supply capital and labour to the firms least likely to survive. As a result, inefficient firms will face tighter price and cost constraints making their continued existence less likely."[121]
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