Competitive foreclosure

• Author: József Sákovics,Roberto Burguet
• Published date: 01 December 2017
• DOI: http://doi.org/10.1111/1756-2171.12206
• Date: 01 December 2017

RAND Journal of Economics

Vol.48, No. 4, Winter 2017

pp. 906–926

Competitive foreclosure

Roberto Burguet∗

and

J´

ozsef S´

akovics∗∗

We model oligopolistic firms, producing substitutes, who compete for inputs from capacity con-

strained suppliers in a decentralizedmarket. Compared to a price-taking input market, the incen-

tive to foreclose downstream competitors leads to higher input prices and to a higher aggregate

amount of input acquired. This novel feature mitigates the output reducing effect of downstream

market power and may even restore efficiency in the unique (input) market clearing equilibrium.

Other equilibria, where firms coordinate on whichsuppliers to target, result in excess supply (in-

voluntary unemployment, if input is labor) and even higher input prices. Our insights generalize

to alternative vertical structures.

1. Introduction

Firms often compete with the same rivals in different, vertically connected, markets: say,

upstream markets for inputs and downstream markets, where they sell their output. When these

firms have significant market power, the resulting strategic interaction can become complex and

closely dependent on market microstructure. In this article, we take a fresh look at the deceptively

straightforward scenario, where the input is provided competitively by a large number of small

(capacity constrained) suppliers. Using a novel model of price determination, we show that the

usual negative welfare effects of downstream market power are mitigated through a feedback

channel to the upstream market that has generally been considered anticompetitive.

Our point of departure is the conventional wisdom that firms engaged in vertical multimarket

competition have an incentive to foreclose: to reduce the rivals’ production by somehow starving

them of input. Models often fail to capture the full ramifications of this observation.1To illustrate

∗University of Central Florida; rburguet@ucf.edu.

∗∗The University of Edinburgh; jozsef.sakovics@ed.ac.uk.

This article supercedes “Bidding for input in oligopoly.” We thank David Myatt (Co-Editor in charge), two anonymous

referees, Simon Board,Ramon Caminal, Michael Elsby, Juanjo Ganuza, Philipp Kircher, Laurent Lamy,Carmen Matutes,

John Moore, Katharine Rockett, Ilya Segal,Michelle Sovinsky, and Ludo Visschers—as wellas audiences at EARIE 2016

(Lisbon), Jornadas de Econom´

ıa Industrial 2016 (Palma), Barcelona GSE, Leicester, Paris SE, Queens College CUNY,

UCF,UCLA, and ZEW Mannheim—for helpful comments. We gratefully acknowledge financial support from the ESRC

(Transparency in Procurement, ES/N00776X/1) and The Spanish Ministry of the Economy and Competitiveness(Grant

ECO2014-59959-P).

1Wepresent a detailed discussion of the related literature below.

906 C2017, The RAND Corporation.

BURGUET AND S ´

AKOVICS / 907

this, assume for the moment that the—atomized—supply of input is completelyelastic. It may then

appear natural—though we will argue that perhaps incorrect—to model upstream competition

as firms simultaneously choosing quantities (as the input price is “given”). It is then clear that

a result of downstream market power is a lower output, resulting in a lower input demand. We

contend that the incentive to increase one’s (input) quantity in order to decrease the rivals’ is

seriously underestimated if we only take account of the strategic substitutability arising from

quantity competition.

Modelling competition in this restricted way implies that a firm cannot directly affect its

rivals’ input levels. We believe that this is an unnecessary, and often unrealistic, constraint. To

address this concern, we propose an alternative microstructure that explicitly takes into account

the firms’ ability and desire to foreclose.

The key feature of our model of the (upstream) market is that the same supplier may be

approached by multiple potential buyers simultaneously, even though she is constrained to deal

with at most one of them.

By targeting specific suppliers, firms can affect whether their purchase is at the expense

of their rivals. By directing their demand at the suppliers that the rivals intend to use, they

can potentially reduce the rivals’ input (and hence, output). When every firm can engage in

such “poaching” activity, the equilibrium strategies incorporate defensive tactics: competitive

foreclosure—characterized by aggressive competition for a subset of suppliers—ensues.

We streamline bargaining by assuming that the firms make take-it-or-leave-it offers to

the suppliers of their choice—or, equivalently, each (unit-)supplier holds a first-price auction.2

Importantly, this mechanism is completely decentralized: each supplier decides independently

who to deal with, given the prices offered to her by the firms—to which the latter areassumed t o

be fully committed.

A novel implication of competitive foreclosure relative to the traditional “raising the rival’s

cost” scenario is that the higher price paid for input is accompanied by an increased input

purchase. The intuition is transparent even before we specify the details of our model: traditional

foreclosure is considered as an asymmetric situation, where Firm 1 forecloses Firm 2 by capturing

the lower part of the supply function, thereby ostracizing its rival to its higher part. Faced with

the higher cost, the foreclosed firm purchases less input. In our setup, the firms are trying to

foreclose each other. As a result of internalizing the externality, the willingness to pay for a unit

of input increases for both firms, leading to a bidding war, resulting in both higher input prices

and higher input volume (where the supply curve is shared symmetrically). Put another way, the

higher price results from a shift in the demand curve, rather than a movement along it.

Our stylized model captures a wide range of scenarios. The inputs firms compete for may

be materials (e.g., mineral ore), parts, or even machinery.3All we need is a large number

of small—capacity constrained or exclusively dealing—potential suppliers. Perhaps the most

obvious example of such input is labor.4However, labor is far from being unique in this respect.

Advertising space for advertisers (on web pages, in newspapers, in broadcasting breaks, etc.), or

shows for pay-TV platforms are among the less ordinary examples of input markets where our

discussion is relevant. When Netflix landed in Europe and was ableto sign some of the successful

TV dramas into its streaming service, local operators, like Canal Plus and Sky, felt it necessary to

find ways, including banding togetherwith operators in other markets, to outbid their new rival for

some of the shows.5That willingness to payfor an input that would otherwise go to the competitor

2Our firms have market power,so they are likely to have bargaining poweras well. Moreover, as wewill see, giving

all the bargaining power to them is not crucial as, due to competition, they will not be ableto benefit from it.

3In fact, for our purposes, it is irrelevant whether the firms add any value: they could be intermediaries.

4The insights that we obtain are most relevantfor labor markets with identifiable individuals like top management,

academics, professionals, etc., where personalized deals are common.

5See “Netflix Global Growth Faces NewThreats,” in The Wall Street Journal, January 17, 2016. (Online edition,

consulted February 9, 2017.)

C

The RAND Corporation 2017.