In a forthcoming paper in the Journal of Economics and Management Strategy, Founding Partner Mark Israel and Senior Consultant Dan O’Brien examine the effects of vertical mergers in settings where investment in technology is a critical competitive strategy.
It is well established in the literature on vertical contracting that the potential for competitive harm from vertical integration (through merger or contract) is greatest in environments where contracts are bilaterally negotiated, which generates bilateral contracting externalities (e.g., O’Brien 1988; Hart & Tirole, 1990; O’Brien and Shaffer, 1992; and other references in paper linked below). That literature, however, abstracts from investment and focuses on the effects of integration on price. But in many economic environments, e.g., semiconductors (as just one example), investment is just as important if not more important as competitive strategy as price. Failure to invest can mean failure to remain competitive.
This paper extends the theory of vertical mergers under bilateral contracting to consider upstream and downstream investments that enhance demand. Investment generates double moral hazard, where reduced investment by a firm at one level in the chain harms firms at the other level. The authors show that vertical mergers mitigate bilateral contracting externalities associated with double moral hazard and hold-up, which leads to an increase in complementary investments. If downstream products are either sufficiently distant or sufficiently close substitutes, a vertical merger benefits the merging firm, consumers, and the unintegrated downstream firm. For intermediate degrees of product differentiation, the authors examine a parameterized model with linear demand and quadratic investment costs. They show that if the marginal cost of investment is sufficiently low, as revealed by a high ratio of R&D investments to sales, a vertical merger is procompetitive. The authors show how to calibrate their model based on pre-merger investment and sales information and apply it a vertical merger in the computer industry.
Abstract:
We extend the theory of bilateral vertical contracting to a double moral hazard setting where upstream and downstream firms make complementary investments that enhance demand; downstream firms make fixed investments to enter the downstream market, and contracts are private information and determined through simultaneous bilateral bargaining. We show that vertical mergers mitigate bilateral contracting externalities and hold-up, which leads to an increase in complementary investments. If downstream products are either sufficiently distant or sufficiently close substitutes, a vertical merger benefits the merging firm, consumers, and the unintegrated downstream firm. For intermediate degrees of product differentiation, a case with linear demand and quadratic investment costs shows that consumers benefit if the marginal cost of investment is sufficiently low as revealed, for example, by a high ratio of R&D investments to sales. We apply the model to a vertical merger in the computer industry.
Read the full article here.
The paper complements the recent paper by Mark Israel and Salvatore Piccolo (with Michele Bisceglia and Paolo Ramezzana), found here.
This article was first published in SSRN here.
The views and opinions expressed in this response are those of the authors and do not necessarily reflect the views of Econic Partners or its clients.
