Can vertical integration by a monopsonist harm consumer welfare?

https://doi.org/10.1016/j.ijindorg.2004.02.002Get rights and content

Abstract

Vertical integration by a monopsonist is generally believed not to harm consumers. This paper demonstrates, in a natural economic setting, that this conventional wisdom may not hold. We model one-on-one bargaining between a monopsonist and independent suppliers when the set of suppliers cannot be expanded easily ex post and show that a vertically separated monopolist is vulnerable to holdup. Without integration, we demonstrate that a bottleneck monopsonist has an incentive to encourage more upstream entry than would arise in a pure neoclassical monopoly. Having more suppliers mitigates the holdup power of any one. This, however, distorts the cost structure of the industry toward greater industry output and, hence, lowers final good prices. Vertical integration mitigates the hold-up problem faced by the monopsonist. It allows it to generate and appropriate a greater level of industry profits, at the expense of consumers.

Introduction

In recent times, questions of how competition policy makers should respond to issues arising from monopsony or buyer power have gained increased prominence. In Europe and the United States, competition authorities have examined the buying power of supermarket and other retail chains EC, 1999, OECD, 1999, FTC, 2001. A similar set of concerns has arisen in the context of health care policy Pitofsky, 1997, Ellison and Snyder, 2001. In general, the focus has been on the consequences of growing monopsony power (through consolidation, mergers and buyer groups) and consequent wholesale price changes rather than what other actions firms with monopsony power might pursue.

While there is some controversy regarding the overall welfare consequences of increased monopsony power, there appears to be a general consensus in the literature that the actions of bottleneck monopsonists—such as vertical integration and exclusive dealing—can only be welfare enhancing for final consumers (Rey and Tirole, in press). Consider vertical integration—the focus of this paper. A downstream monopsonist who integrates backwards into upstream supply will do so to increase its own profits. As it controls the means by which inputs get translated into goods for final consumers, the only way it can improve its profits is by lowering its own costs. If cost reduction involves any reduction in marginal costs, that will lower final good prices and enhance consumer surplus even where there is a downstream monopolist. Inefficient vertical integration that either reduces the investment incentives of suppliers or forecloses on them will only be undertaken if it reduces the input costs of the monopsonist. Consequently, it must involve some beneficial reduction in double marginalisation or improvement in the bargaining position that overwhelms any other efficiency costs. As such, even if there is an overall reduction in welfare, the monopsonist and its consumers will always benefit.1

For this reason, research into the competitive detriments of backwards integration has focussed on the case of duopsonists or oligopsonists who compete with each other downstream. In that case, vertical integration can raise a rival's costs and thereby harm downstream competition Salop and Scheffman, 1983, Ordover et al., 1990, Hart and Tirole, 1990, Choi and Yi, 2000, Chen, 2001, de Fontenay and Gans, 2004.2 In these models, the use of vertical integration is not so much a leverage of buying power but a means of consolidating and leveraging upstream market structure downstream. The basic idea is that by foreclosing on an upstream firm, other nonintegrated downstream firms are left vulnerable to the exercise of upstream market power. As such, these are really theories of how vertical integration harms consumer welfare as a result of monopolistic rather than monopsonistic forces per se.3

The purpose of this paper is to demonstrate that it is possible that vertical integration by a monopsonist into upstream supply can lead to a reduction in consumer welfare in the downstream market. We do this in a setting with standard assumptions regarding the nature of upstream costs and where inputs supplied by upstream firms are homogenous and play no unusual role in downstream production or final good demand. Consumer harm arises because vertical integration enables a change in upstream market structure in such a way that industry marginal costs are higher than they would be in the absence of integration. They are higher precisely because integration allows the monopsonist to foreclose on some upstream suppliers. What is significant here is that the monopsonist finds this profitable. This is because the changes in upstream market structure allow it to capture greater inframarginal rents.

At the heart of our model is a treatment of bilateral negotiations between the monopsonist and independent suppliers based on the model of Stole and Zwiebel (1996)—hereafter SZ. In contrast to much of the literature, we provide an environment where upstream firms have some degree of bargaining power in negotiations with the monopsonist even when there are many of them. Specifically, we suppose that supply contracts can be renegotiated more often than there can be changes in upstream market structure (either through entry or integration). Consequently, failure to reach an agreement with one upstream firm is costly to the monopsonist as it improves the bargaining position of the remaining suppliers.

We demonstrate that a nonintegrated monopsonist, anticipating ongoing negotiations with upstream suppliers, has an incentive to deal with more of these than would arise if it were a textbook monopsonist holding all the bargaining power with those firms. By integrating some upstream units, the monopsonist can assure itself of supply regardless of the outcome of negotiations with independent upstream firms. This improves its bargaining position and allows it to commit to not purchase from as many upstream firms; shifting the industry supply curve to the left to the ultimate harm of consumers. Put simply, integration allows the monopsonist to reverse the incentives for overcapitalisation that would otherwise exist upstream. In this sense, vertical integration plays a supply assurance role distinct from that considered elsewhere; allowing the bottleneck firm to assure itself of low prices rather than cause a reduction in supply available to other firms.4

While we provide a novel treatment of the incentives and consequences of vertical integration by a monopsonist, some of the insights from the bargaining game as well as the consequences of vertical integration are present in related work. For instance, Inderst and Wey (2003) and Bjornerstedt and Stennek (2002) consider a closely related model of bilateral oligopoly where both upstream and downstream firms have bargaining power. Neither of these models is used to study vertical integration focussing instead on the effect of horizontal integration and the distribution of input prices, respectively. Chemla (2003) demonstrates that vertical integration can allow the upstream firm to mitigate that bargaining power and hence, to reduce downstream competition (see also Rey and Tirole, in press). His ‘negotiation’ effect is similar to that identified in this paper but his particular bargaining model does not give rise to an explanation for integration by a monopsonist.5

The outline for the paper is as follows. In Section 2, we set up the model structure and main assumptions. Section 3 then considers the outcomes of multiagent bargaining. We demonstrate that negotiated outcomes result in ex post efficiency, i.e., efficiency in production and sale decisions, given the entry and investment decisions of all agents. Second, the monopsonist purchases from enough independent firms to appropriate all of the industry rents. This latter implication directly leads to the overproduction result studied in Section 4. However, in that section, we also demonstrate how this creates an incentive for vertical integration that leads to lower industry output and higher prices compared with the vertical separation case. We also demonstrate that consumers are better off as vertical integration becomes more costly for the monopsonist. A final section concludes and offers suggestions for future research.

Section snippets

Basic setup

We consider the case of a monopsonist who buys a homogenous input from upstream suppliers. For simplicity, we assume that the downstream firm has no production costs. An upstream firm, i, can produce qi units of the input at cost c(qi). We assume that c(·) is convex for any qi>0 with c′(0)=0 and c(0)=0. We assume that all costs can be recovered if the firm exits the industry prior to producing anything. Thus, while there are fixed costs these are not sunk; essentially representing the

Bargaining outcomes

Working backwards, we consider first the outcomes of the bargaining game specified above. In particular, we focus upon both the surplus generated in the industry as well as the distribution of that surplus.

The strategic role of integration

We now turn to investigate the strategic role of vertical integration. Eq. (4) means that, regardless of the degree of integration, the monopsonist will designate sufficient numbers of independents so that it earns the entire value of industry profits through one-on-one negotiations with them. Ex post efficiency means that the realised level of industry profits will be efficient given the number of available independent and integrated units. In this environment, it can be demonstrated that the

Conclusions

Previous models of vertical integration by a monopsonist, despite demonstrating in some cases a potential reduction in overall welfare because of changes in supply conditions or investment incentives, have found integration to be to the benefit of consumers. The reason is that, by definition, a monopsonist controls how inputs get transformed into economic value from consumers and cannot generate more than one downstream monopoly rent from this channel. Instead, vertical integration—whether it

Acknowledgements

This paper was previously circulated with the title “Extending Market Power through Vertical Integration.” The authors would like to thank Tim Bresnahan, Stephen King, Preston McAfee, Lars Stole, Jeff Zwiebel, two anonymous referees and the editor for helpful comments. Responsibility for all errors remains our own.

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