Anti-Competitive Effects of Vertical Integration

Economists have identified several conditions under which vertical integration could be welfare-reducing, including:

	Market foreclosure
	Raising rivals' cost through vertical integration

Issue: If a cement supplier integrates downstream into the ready mix concrete business, will this affect its rivals in the cement business? And what are the welfare implications?

To get at this question, we present the model suggested by Allen [see Bruce T. Allen, "Vertical Integration and Market Foreclosure: The Case of Cement," Journal of Law and Economics, April 1971].

Assumptions:

Click here to see the graph. Note the following:

	Prior to the (vertical) merger, there are 20 cement supplier and 20 ready mix concrete suppliers, each supplying 75,000 tons of cement and concrete, respectively.
	Ace Cement has purchased a single concrete supplier (Jones Ready-Mix Concrete).
	The withdrawal of Ace and Jones from the cement market is illustrated by a shift of the supply and demand functions from S to S' and D to D', respectively
	The price and total output of cement is unchanged; however, the quantity subject to market transaction is reduced by 75,000 tons.
	Rival cement suppliers are unaffected; though the distribution of their sales among concrete firms may change since Jones is no longer in the market for cement (having been merged with Ace).
	Ace's share of cement production is unchanged.
	Hence the merger is welfare-neutral

Now consider the case where Ace acquires two concrete companies, Jones and Smith. Click here to see the graph. Note the following:

	Now Ace will increase its share of cement production at the expense of rivals. However, if it maximizes profits from the sale of cement, the price of the marginal ton will exceed $100 and its production of cement will fall short of 150,000 tons.
	Profits from the sale of cement are given by CFE (as compared to CAB if it had remained non-integrated), if Ace charges the "maximum" transfer (or internal accounting) price for each unit of cement.
	If the firms remained non-integrated, then combined profits of the three units are given by: CAB + AFG. Hence, by merging and charging the transfer price to maximize profits from the cement operations of the firm, combined profits are actually reduced by BEG.
	The second iteration of the model illustrates that Ace has an incentive to establish an internal transfer price of $100 so as to maximize profits from the production of cement and concrete.
	The downstream purchase of two concrete suppliers by Ace leaves that market with 19 sellers. Thus, the consolidation may not be welfare-neutral.

Suppose that a personal computer manufacturer (Hi-Tec) integrates backward into the production of memory chips. Moreover, suppose that the non-foreclosed segment of the memory chip industry is now more tightly concentrated than before-- to the degree that the remaining chip makers engage in "joint profit maximization." We can show that, by integrating backward, Hi-Tec has effectively raised the price that rival computer makers must pay for memory chips. See graph. Note the following:

	If vertical integration has no significant effect on the structure of the computer chip industry, then rival PC makers continue to pay P_o for memory chips.
	If, however, vertical integration gives rise to monopolistic pricing in the market for memory chips, then rivals will pay P₁ per unit.
	If the latter scenario holds forth, then Hi-Tec has established a barrier to entry into the PC industry--i.e., an absolute cost advantage. The structure of memory chip industry is now further removed from the competitive ideal.
	Mergers in this category are unambiguously welfare-reducing.

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