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Vert. Integration and Mergers 1

Industries are collections of economic activities at successive stages of production; some begin with natural resource extraction and end with delivery of products to final consumers. Industry example Forests (Federal gov’t) Logging (Small independent) Pulp mills (Georgia-Pacific)

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Vert. Integration and Mergers 1

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  1. Industries are collections of economic activities at successive stages of production; some begin with natural resource extraction and end with delivery of products to final consumers. Industry example Forests (Federal gov’t) Logging (Small independent) Pulp mills (Georgia-Pacific) Paper mills (Nakoosa) Finished papers (Eaton) Greeting card production (Hallmark) Wholesale distribution Retail card sales Vert. Integration and Mergers 1

  2. Vert. Integration and Mergers 2 • A firms is a collection of activities, some of which may be from different stages of production • A firm is vertically integrated if it internally transfers and processes products from one stage to another when it could obtain intermediate input products in a market (backward integration) or could sell intermediate output products in a market (forward integration)

  3. Vert. Integration and Mergers 3 • Incentives to integrate • Gain monopoly power • Even in competitive markets, reduce costs • Technological interdependence allows savings • Reduced transactions costs: search costs, negotiation cost, enforcement costs • Managerial economies (but there may be managerial diseconomies)

  4. Vert. Integration and Mergers 4 • Both mkts. competitive = no merger incentive • Profit without integration = 0 • Profit = 0 with upstream (backward) integration when one candied apple producer buys one apple producer • Profit = 0 with downstream (forward) integration when one apple producer buys one candied apple producer P c MC candied apples = MC apples +MC transformation P a MC apples MC transformation (apples into candied apples) D candied apples D apples Q where P candied apples = MC candied apples Q where P apples = MC apples

  5. Vert. Integration and Mergers 5 • Monopoly in apples = no merger incentive • Profit without integration for the monopoly apple producer = (P’a-MCa)*Q’a • Downstream (forward) integration: the monopoly apple producer buys a candied apple producer and since there is no longer a source of apples for other producers, there is monopoly in candied apples. Profits for the integrated monoplolist = (P’c-MC’’c)*Q”c, but this is the same as profit without integration P’c MC’ candied apples = P’ apples +MC transformation P’a MC’’ candied apples = MC apples +MC transformation P c P a MC apples MR candied apples MC transformation (apples into candied apples) D candied apples MR apples D apples Q’ ca where P candied apples = MC’ candied apples Q’a where MR apples = MC apples Q’’ca where MR candied apples = MC” candied apples

  6. Vert. Integration and Mergers 6 • Successive monopoly = merger incentive • Profit without integration for the monopoly apple producer = (P’a-MCa)*Q’a P’c MC’ candied apples = P’ apples +MC transformation MC’’ candied apples = MC apples +MC transformation P a MC apples MR candied apples MC transformation (apples into candied apples) MR’a D candied apples MR a=D’a D apples

  7. Vert. Integration and Mergers 7 • A monopolist selling inputs to producers that vary their input combinations depending on input prices has an incentive to merge to increase profits $ worth of all other inputs Y1X1 is the least cost isocost line for producing Q* units of output when the monopolist charges monopoly Px>MCx. Y1 is the total cost of producing Q* at A. Y1X2 is the same total cost as on Y1X1 but the monopolist charges only MCx for input X. Q* units of output can be produced now for only a cost of Y2 at B. Y2X3 is the least cost way of producing Q*units of output with the lower price for input X. Y2 is now the total cost of producing Q* at B. The cost saving of Y1-Y2 can be captured by the monopolist as profit if the monopolist acquires a downstream firm. The social welfare implications are uncertain. Isoquant showing different ways of producing exactly Q* units of output using units of the input X and all other inputs measured in $ worth. Y1 A Y2 B Quantity of input x sold by a monopolist X2 X1 X3

  8. Vert. Integration and Mergers 8 • In spite of economic arguments that indicate that vertical mergers may not harm social welfare or even competition in many cases, the courts have opposed mergers on two grounds • Market foreclosure for input purchases or output sales • Reductions in potential competition • Barriers to entry if new firms (after old firms merge) must enter at more than one level of production

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