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Competition law reading session 3 (theory) Whinston and Bolton, 'The Foreclosure Effect of Vertical Mergers' , Journal of International and Theoretical Economics
The Chicago school says that vertical mergers should not be prohibited. Bork argues that foreclosure after a merger will never be profitable: o If a manufacturer (M) acquires a retailer (R), and says that R can only sell M's products, which are more expensive or less desirable than those of rival manufacturers, any extra sales made by M will be outweighed by losses incurred by R.
Oliver, Saloner and Salop (OSS) refute this, arguing that a vertical merger can have strong anticompetitive effects. o If an upstream firm merges with a downstream firm, the upstream firm has less of an incentive to cut costs and become more efficient (since it has no need to find a retailer to buy its products). As a result other upstream rivals can also start charging higher prices and remain competitive, so that the purchase price for retailers goes up and pass on higher prices to consumers. o Problem is that this doesn't say why integration means a firm can afford to compete less freely. If the integrated firm is still in pursuit of profits and still has to face rivals at some point (namely at the point of sale to consumer rather than to retailer), then it will still seek efficiencies at both stages of production.
Williamson, 'The Vertical Integration of Production: Market Failure Considerations,' University of Pennsylvania
Vertical Integration is an anomaly given market theory: If the cost of operating in a (perfectly competitive) market is zero (no barriers etc) then why would two firms integrate?
o One answer might be the production for certain goods is more efficient e.g. the same/similar equipment can be used to make iron into steel so it's more efficient to make them on the same site rather than incur the cost of transportation to a new site.
The substitution of internal organisation for market transactions following integration is called internalisation. Market transactions are generally preferable to internal supply because market has greater rationality and there are often difficulties with internal administration following integration. However internal organisation may be preferable where the firm can deal with transaction disputes better than a firm could with a customer and has the necessary tools to give rewards and stipulate penalties for performance (promotions etc). The firm can avoid protracted bargaining or litigation where disputes arise.
In cases of market failure, vertical integration might be rational o Where there's a bilateral monopoly (monopoly buyer and seller) a merger might avoid long term negotiations on price and quantity (though a long term contract could avoid this too, and merger itself requires lengthy bargaining process). o Integration can avoid the problems of contracts: Long term contracts might be subject of litigation and can't deal with new technology that leads to product redesign; short term contracts require renegotiation; 'cost plus' and 'fixed price' contracts pose uncertainty for buyer and seller respectively, so that it makes more sense to negate the risk through integration. Furse, Competition Law of the EC and UK,' Chapter 18:
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