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Description
This article uncovers an unnoticed connection between exclusive contracts and vertical organization. A vertically integrated firm can use exclusive dealing to foreclose an equally efficient upstream competitor and to cartelize the downstream industry. Neither vertical integration nor exclusive dealing alone achieves these anticompetitive effects. The cartelization effect of these two practices may be limited when downstream firms are heterogeneous and supply contracts are not contingent on uncertain market conditions. The extent of cartelization also depends on the degree of downstream market concentration and on the degree to which downstream competition is localized.
1. Introduction
* Antitrust scholars have devoted much ink to the competitive effects of vertical mergers (Riordan and Salop, 1995). For the most part, the economics literature focuses on how vertical integration per se alters pricing incentives in relevant upstream and downstream markets. The Chicago school of antitrust, represented by Bork (1978), emphasizes that the efficiencies of vertical integration are likely to cause lower prices to final consumers, while a more recent strategic approach to the subject, represented by Ordover, Saloner, and Salop (1990) and Hart and Tirole (1990), shows how vertical integration lacking any redeeming efficiencies might have the opposite purpose and effect. Ma (1997), Choi and Yi (2000), Church and Gandal (2000), and Chen (2001) consider richer models that feature trade-offs between anticompetitive effects and efficiencies. The debate is far from settled, in no small part because workable indicia of harmful vertical mergers are lacking except in special cases (Riordan, 1998).
The use of exclusive contracts by customers and suppliers in intermediate product markets is equally controversial. The courts and antitrust agencies historically have treated exclusive dealing harshly, finding in many cases such practices illegally foreclose competition. The Chicago school disputes this approach, advising instead that exclusive contracts are presumptively efficient, because usually it is unprofitable to foreclose competition via exclusive contracts without good efficiency reasons (Bork, 1978). More recently, industrial organization economists have studied alternative models that demonstrate equilibrium incentives to foreclose more efficient potential entrants with exclusive contracts (Aghion and Bolton, 1987; Bernheim and Whinston, 1988; Rasmusen, Ramseyer, and Wiley, 1991; Segal and Whinston, 2000; Spector, 2004).
An important institutional feature of some intermediate product markets is the coexistence of vertical integration and exclusive contracts. For instance, in Standard Oil Co. v. U.S. (1949), Standard Oil sold about the same amount of gasoline through its own service stations as through independent retailers with which it had exclusive dealing contracts. In Brown Shoe Co. 62 F.T.C. 679 (1963), Brown Shoe had vertically integrated into the retailing sector while using exclusive dealing contracts with independent retailers. In U.S. v. Microsoft (D.D.C., 2000), Microsoft had license agreements with competing online service providers, requiring them to promote and distribute Microsoft's Internet Explorer to the exclusion of competitive browsers. This institutional feature is potentially important because, as we shall show, the incentive for and effects of exclusive contracts may depend on whether an upstream supplier is vertically integrated, and, conversely, the returns to vertical integration may depend on the possibility of exclusive contracting.
While the existing economics literatures on vertical integration and exclusive contracts yield important insights on the competitive effects of these practices used in isolation, the literatures generally ignore incentives for and effects of these practices in combination. The purpose of this article is to uncover an unnoticed connection between exclusive contracts and vertical integration and to develop a model for analyzing how these practices complement each other to achieve an anticompetitive effect. More specifically, we argue that a vertically integrated upstream firm has the ability and incentive to use exclusive contracts to exclude equally efficient upstream competitors and control downstream prices. (1) The ex post effect is a cartelization of the downstream industry. Neither exclusive dealing nor vertical integration alone has this anticompetitive effect.
The article is organized as follows. Section 2 previews our basic ideas. We illustrate the relationship between vertical integration and exclusive dealing in a simple model of industrial organization with two identical upstream and two identical downstream firms. We then discuss complications that arise with heterogeneous downstream firms when competitive advantage is uncertain and noncontractible, thus providing a transition to our main model of bilateral duopoly. The main model studied in Section 3 combines upstream requirements contracting with downstream bidding to serve final customers. In this model, one or the other downstream firms has an ex post competitive advantage in selling to a particular customer, but these downstream advantages are not contractible ex ante when requirements contracts are struck. We demonstrate in this context the ability of a vertically integrated firm profitably to employ an exclusive contract that raises input prices and cartelizes the downstream duopoly. We further show that exclusive contracts do not achieve this anticompetitive effect if the industries are vertically separated and discuss extensions to bilateral oligopolies and to private rather than public requirements contracts. Section 4 reviews some key features of our model of downstream competition, discusses the robustness to other models of downstream competition, relates our results to previous economics literature, discusses two relevant antitrust cases, and discusses policy implications.
The Appendix proves the formal results of Section 3. A separate Web Appendix, available at www.rje.org/main/sup-mat.html, discusses two alternative spatial models of downstream markets with multiple independent competitors: a hub-and-spokes model of nonlocalized competition and a circle model of localized competition. The results obtained earlier extend naturally to these models of bilateral oligopoly, with additional insights that the extent of upstream foreclosure and downstream cartelization depends on the nature of competition and on concentration in the downstream market.
2. Basic ideas
* That vertical integration and exclusive dealing can combine to foreclose an equally efficient upstream competitor and to raise downstream prices is easy to demonstrate in a simple model of industrial organization. Suppose there are two identical upstream firms, U1 and U2, and two identical downstream firms, D1 and D2. The downstream firms require one unit of an intermediate good to produce one unit of the final good, for which identical consumers have a known reservation price, V. Upstream costs are normalized to zero and downstream costs per unit of production are equal to C < V. If the firms are independent, then Bertrand competition in the upstream market followed by Bertrand competition in the downstream market results in a final goods price equal to C. Against this backdrop, a vertically integrated U1-D1 has an incentive to purchase an exclusive right to serve the downstream market and charge final consumers a price equal to V. For example, U1-D1 might pay D2 to withdraw from the market, or, alternatively, acquire D2. Such blatant monopolization likely would meet objections from antitrust authorities. More benign in appearance is an exclusive requirements contract that achieves the same anticompetitive effect. A contract that requires D2 to purchase from U1 at a price of V - C fully extracts monopoly rents from the downstream market. Firm U2 is excluded from the upstream market, and final consumers pay V to purchase from either D1 or D2. (2)
It is interesting that D2 does not need much persuasion to agree to purchase its requirements exclusively from U1-D1 on noncompetitive terms. If D2 were to decline an exclusive requirements contract with U1-D1 and instead were to deal with U2 on competitive terms, then vigorous competition from D1 would squeeze out downstream profits to the point where D2 would be happy to have fallen into U1's exclusive arms for a small concession, e.g., a small fixed fee. The Chicago school correctly observes that a downstream firm must be compensated to agree to forgo the benefits of upstream competition (Bork, 1978), but the above simple model shows that the necessary compensation need not be large if the firm has little to lose because of vigorous downstream competition. (3) An exclusive contract effectively monopolizes the downstream industry, and the monopoly rents can be shared in some measure by all concerned firms.
It also is interesting that neither vertical integration nor exclusive dealing alone can be counted on to achieve these anticompetitive effects if contracts are bilateral. The vertically integrated U1-D1 could not persuade the independent D2 to pay a supracompetitive price for the intermediate good without an exclusive contract because D2 would retain an expost incentive to purchase from U2 on competitive terms and cut its retail price to steal business from D1. Similarly, unable to commit to a multilateral contract that binds both D1 and D2, a vertically separated U1 is unable to pay D1 and D2 enough to induce them both independently to forego the competitive alternative. Thus, vertically separated upstream firms in equilibrium maximize bilateral profits by offering each downstream firm an efficient two-part tariff that sets the unit price of the intermediate good equal to marginal cost. (4)
Matters are more complicated if downstream market conditions are uncertain and noncontractible. Suppose that C is a random variable and that the realization of C becomes known after contracting for the intermediate good but before setting downstream prices. Suppose further that requirements contracts take the form of uncontingent two-part tariffs. Then monopolization of the downstream industry by UI-D1 is accomplished with an exclusive requirements contract that excludes D2 by setting the marginal price of the intermediate good above all possible values of V - C. Otherwise, competition from D2 would drive the downstream price below the monopoly level in some states of the world. Thus, under conditions of uncertainty and noncontractibility, U1-D1 can use an exclusive contract effectively to purchase a monopoly right. The contract is hardly subtle, and such blatant exclusion likely would catch the attention of antitrust authorities.
Matters are complicated further by downstream heterogeneity. If some consumers prefer D2's product or are more cheaply served by D2, then a requirements contract that excludes D2 obviously cannot fully maximize industry joint profits. Rather, a fully effective ex post cartelization of the downstream industry would require coordinated pricing that divides the downstream market efficiently. For example, if random downstream costs have different realizations for D1 and D2, then it is efficient to assign final consumers to the low-cost firm. But if these uncertain downstream market conditions are noncontractible, then U1-D1 would have the conflicting incentives both to exclude and not to exclude D2. U1-D1 generally is unable both to divide the market efficiently and to fully extract rents with a two-part tariff that D2 would accept. Thus, the combination of uncertainty, noncontractibility, and heterogeneity appear to create difficulties for ex post cartelization via vertical integration and exclusive dealing.
To understand fully the relationship between vertical integration and exclusive dealing, therefore, it is important to go beyond the simple case of homogeneous downstream firms and to study the relationship under conditions of downstream heterogeneity, uncertainty, and noncontractibility. In what follows, we analyze a game-theoretic model of an industry possessing these features. This analysis will make clear several points. First, the synergistic relationship between vertical integration and exclusive dealing is not due to the extremely vigorous nature of potential downstream competition between identical producers; rather, it holds more generally in the presence of heterogeneous downstream firms that possess some degree of market power. Second, while the vertically integrated firm has the incentive and ability to exclude upstream competition and cartelize the downstream market, its ability to do so may be reduced with downstream heterogeneity and noncontractible uncertainty. In particular, the fixed payment needed to persuade D2 to enter the exclusive contract may not be small when downstream firms are heterogeneous, (5) and only partial cartelization of the downstream industry is feasible when downstream monopoly prices vary with noncontractible market conditions. Third, extending the model to multiple independent downstream competitors, while maintaining the assumption of bilateral contracting, reveals that the degree of ex post cartelization of the downstream industry depends on market concentration and on whether or not competition is localized. Fourth, the exclusive contracts that a vertically integrated firm uses to cartelize the downstream industry are not blatant antitrust violations. The vertically integrated firm subtly employs the marginal wholesale price of a two-part tariff to raise the downstream price and judicially employs the fixed fee to distribute the rents from cartelization.
3. Heterogeneous downstream firms
* In this section, we study the main model of the article. After introducing the model, we consider a benchmark case in which an upstream monopolist is vertically integrated with one of the downstream duopolists. We then introduce an equally efficient nonintegrated upstream competitor and prove that, in equilibrium, the vertically integrated firm profitably employs an exclusive contract to achieve the same market outcome as in the upstream monopoly case, except for the distribution of rents between the upstream and downstream industries. We further show that exclusive contracts are irrelevant if the industries are vertically separated. We complete this section by discussing what happens if the model is extended to allow multiple independent downstream... |
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