Passive vertical integration and strategic delegation

• Author: Matthias Hunold,Konrad Stahl
• Published date: 01 November 2016
• DOI: http://doi.org/10.1111/1756-2171.12158
• Date: 01 November 2016

RAND Journal of Economics

Vol.47, No. 4, Winter 2016

pp. 891–913

Passive vertical integration and strategic

delegation

Matthias Hunold∗

and

Konrad Stahl∗∗

With backward acquisitions in their efficient supplier, downstream firms profitably internalize

the effects of their actions on their rivals’ sales, while upstream competition is also relaxed.

Downstream prices increase with passive, yet decrease with controlling acquisition. Passive

acquisition is profitable when controlling acquisition is not. Downstream acquirers strategically

abstain from vertical control, thus delegating commitment to the supplier, and with it high

input prices, allowing them to charge high downstream prices. The effects of passive backward

acquisition arereinforced with the acquisition by severaldownstream firms in the efficient supplier.

The results are sustained when suppliers charge two-part tariffs.

1. Introduction

Partial acquisitions among horizontally and vertically related firms are very common,

although their effects have rarely been analyzed.1We contribute by demonstrating the incentives

∗Heinrich Heine Universit¨

at D¨

usseldorf, D¨

usseldorf Institute for Competition Economics; hunold@dice.hhu.de.

∗∗University of Mannheim, CEPR, CESifo, and ZEW; kos@econ.uni-mannheim.de.

This research originated from very fruitful discussions with Lars-Hendrik R¨

oller. Financial support from the Deutsche

Forschungsgemeinschaftthrough SFB TR-15 is g ratefullyacknowledged. We benefitted from presentations of this workin

seminars at Athens, Auckland, Bocconi, Florence, Humboldt, Regensburg,and Tilburg Universities; the IFN Stockholm;

at the EARIE and MaCCI Annual Conferences 2012, Rome and Mannheim; the ANR-DFG Annual Workshop 2012,

Toulouse; the CEPR IO meeting 2013, Cyprus; the SFB TR-15 Workshop 2013, Tutzing; and the ACE Annual meeting

2013, Bruxelles. Wethank Kai-Uwe K¨

uhn, Johannes Muthers, VolkerNocke, Fausto Pannunzi, Lars Persson,Patrick Rey,

David Sauer, Yossi Spiegel, Jean Tirole; and especially the Editor, Mark Armstrong, and two referees; Jacques Cr´

emer,

Marco Ottaviani, Nicolas Schutz, and Yaron Yehezkel for constructive comments; and Thorsten Doherr and Christoph

Wolffor competent research assistance.

1The frequency of partial acquisitions in related firms is well documented by Allen and Phillips (2000). They show

that in the United States, 53% of corporate block ownership involves firms in related industries. In the 2014 waveof the

Mannheim Enterprise Panel, we found that of all German firms with more than 20 employees reported in that database

with financial interests in one or more firms in the same NACE two- and three-digit industry,32% and 33% respectively,

held minority stakes. Industries were classified according to NACE—the statistical classification of economic activities

in the European Union. As only “substantive ownership”shares are recorded in that survey, these percentages are a lower

bound.

C2016, The RAND Corporation. 891

892 / THE RAND JOURNAL OF ECONOMICS

of downstream firms to acquire financial interests in their suppliers, as well as the effects of

these acquisitions on upstream and downstream prices and the profitability of the firms. The

direction of acquisition—backward versus forward—is irrelevant in the conventional models of

full integration. The integrated firm is assumed to own 100% of the assets of both original firms

and to maximize their joint profit. By contrast, the direction of acquisition matters under partial

integration. Moreover, it also matters whether the acquisition is passive or controlling.

Similar to a vertical merger, both passiveand controlling forward integration of an upstream

supplier in its customers tends to induce vertical coordination, by reducing doublemarginalization

and thus downstream prices. Obviously, this is consumer surplus increasing and procompetitive.

By contrast, we show that passive backward integration induces horizontal coordination, exac-

erbates double marginalization, and increases downstream prices, which is consumer surplus

reducing and anticompetitive. We also show that—in contrast to full backward integration—

passive backward integration tends to be profitable for the integrating firms. This provides an

answer to one of the questions addressed in this article, namely, is passive partial backward

integration really as innocent as presently believed, with respect to anticompetitive effects such

as increasing prices or foreclosure?

To derive this answer, we consider a pair of vertically related competitive markets. The

downstream firms produce differentiated products and the upstream firms a homogeneous one.

The upstream firms have different marginal production costs. The downstreamfir ms mayacquire

financial interests in their suppliers, which may be passive or controlling, with passive interests

involving pure cash flow rights; namely, claims only on the target’s profits without controlling its

decisions.

Fixing first the distribution of these interests, we look at the firms’ unrestricted pricing

decisions in both downstream and upstream markets. We concentrate on the case in which

upstream competition is effective in the sense that the efficient supplier’s pricing decision is

restricted by the next-best competitor’s marginal cost. We subsequently explore the downstream

firms’ incentives for backward integration.

Weborrow this interesting and—we feel—empirically relevant setup from Chen (2001), with

the essential difference that we consider the incentives to unilaterally or multilaterally acquire

passive partial, as opposed to controlling full backward financial interests, as well as the effects

of such acquisitions. This difference substantially changes the economics of vertical interaction

between the firms. Weshow that in our model, downstream prices increase with the acquisition of

the typical downstream firm’s passive interests in the efficient supplier; bycontrast, they decrease

with the acquisition of controlling interests. Furthermore, passive partial backward integration is

profitablewhen controlling full backward integration is not. It follows that unlike fully controlling

vertical integration, passive partial backwardinteg ration givesrise to competition policy concerns.

A simple example should convey the intuition for our argument.Let a supplier Uproduce at

zero marginal cost and sell its products to two competing retailers Aand Bat a unit price of 100,

the cost at which each retailer could alternatively procure from a less efficient competitor—or a

competitive fringe. Let retailer Aacquire a noncontrolling financial interest in supplier Uthat

allows it to absorb 25% of U’s profit, whereas Bremains nonintegrated. Accordingly, Aabsorbs

25% of the profit obtained by Ufrom selling goods to B. The margin thus obtained on sales

diverted to its competitor Bincentivizes Ato rais e its price, just as if it had directly acquired a

financial interest in B.

However, with all else given, Ais also incentivized to reduce its price, as for each unit of

input purchased from Uat a nominal price of 100, Aobtains 25% back through its financial

interest in U. This reduces A’s effective unit input price to 75, which, all else given, induces A

to optimally charge a lower price to consumers. The reduction in double marginalization would

thus need to be weighed against A’s incentive to divert sales to B, whereby on balance passive

backward integration could well be procompetitive.

Now, given that the shares of supplier Uacquired by Aare noncontrolling, Ucontinues

to maximize its own profits. Thus far, A’s effective postacquisition unit input price is only 75,

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