Upstream Mergers, Downstream Competition, and R&D Investments

• Published date: 01 December 2013
• Author: Apostolis Pavlou,Chrysovalantou Milliou
• DOI: http://doi.org/10.1111/jems.12034
• Date: 01 December 2013

Upstream Mergers, Downstream Competition, and

R&D Investments

CHRYSOVALANTOU MILLIOU

Department of International and European Economic Studies

Athens University of Economics and Business

Athens 10434, Greece

cmilliou@aueb.gr

APOSTOLIS PAVLOU

Department of Economics

Athens University of Economics and Business

Athens 10434, Greece

pavlou@aueb.gr

In this paper, we provide an explanation for why upstream firms merge, highlighting the role of

R&D investments and their nature, as well as the role of downstream competition. We show that

an upstream merger generates two distinct efficiency gains when downstream competition is not

too strong and R&D investments are sufficiently generic: The merger increasesR&D investments

and decreases wholesale prices. We also show that upstreamfirms merge unless R&D investments

are too specific and downstream competition is neither too weak nor too strong. When the merger

materializes, the merger-generated efficiencies pass on to consumers, and thus, consumers can be

better off.

1. Introduction

Mergers among manufacturers of either intermediate or final products are a very com-

mon business phenomenon. They can be found in various industry sectors. For instance,

car equipment suppliers merge with each other (Kolben-schmidt/Pierburg), and so do

producers of chemical substances (BASF/Engelhard), as well as mobile phone manu-

facturers (Sony/Ericsson).1

A quite common characteristic of mergers among manufacturers is that the merged

firms do not sell their products directly to consumers. Usually, they sell their products to

other firms, final product manufacturers, or retailers, which then provide the products

We thank Stephane Caprice, George Deltas, Emmanuel Petrakis, Patrick Rey, Nikolaos Vettas, the co-editor,

and two anonymous referees for their useful comments and suggestions. Wealso thank seminar participants

at the Toulouse School of Economics, the Athens University of Economics and Business, and the CERGE-EI

(Prague), as well as conference participants at the 7th International Industrial Organization Conference at

Boston, the 8th Conference on Research on Economic Theory and Econometrics at Tinos,and the ASSET 2009

conferenceat Istanbul. This is a substantially revised version of the previously circulated “Upstream Horizontal

Mergersand Efficiency Gains,” CESifo Working Paper 2748. This research has been cofinanced by the European

Union (European Social Fund—ESF) and Greek national funds through the Operational Program “Education

and Lifelong Learning” of the National Strategic Reference Framework (NSRF)—Research Funding Program:

Heracleitus II—Investing in knowledge society through the European Social Fund. Full responsibility for all

shortcomings is ours.

1. Moreover,there have been proposed mergers among baby food manufacturers (Heinz/Beech-Nut) and

among cigar producers (Swedish Match/Scandinavian Tobacco). For additional examples see Froeb et al.

(2007).

C2013 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume22, Number 4, Winter 2013, 787–809

788 Journal of Economics & Management Strategy

to consumers. In other words, typically mergers among manufacturers involve firms

that operate in the upstream sectors of vertically related industries.

One of the recent concerns of the antitrust authorities in the treatment of mergers

between manufacturers is whether they should take vertical relationships into account

(see e.g., Scheffman and Coleman, 2002; Froeb et al., 2004,2007). That is, whether they

should consider the downstream behavior when they examine upstream merger pro-

posals. Such a concern is mainly motivated by the recent increase in retail concentration,

which implies that the assumption of many studies examining manufacturer mergers

that retailers are passive is quite unrealistic.

In this paper, we study upstream mergers in vertically related industries. A key

aspect of our analysis is that we allow for R&D investments and we consider the role

of their nature, whether they are specific or generic. Two additional key aspects of our

analysis are that we endogenize the contract types used in vertical trading and we

take into account downstream competition and its intensity. We address a number of

questions such as: Why and when upstream firms merge? Do upstream mergers lead to

efficiency gains? How do they influence vertical trading? Are their potential efficiency

gains passed on to consumers? Do upstream mergers harm welfare?

In our model, there are initially two upstream and two downstream firms with

exclusive relations among them. In the outset, the upstream firms decide whether they

will merge. Next, they choose among trading through wholesale price contracts or

two-part tariff contracts, they invest in R&D and they set the contract terms.2Finally,

the downstream firms compete in quantities. We allow for various degrees of R&D

investments’ specificity. If the R&D investments are fully specific, they can be used in

the production of the input of just one downstream firm. Otherwise, they can be used

in the production of the inputs of both downstream firms.

We find that a merger can alter the equilibrium contract types. Premerger, firms

trade always through two-part tariff contracts. Two-part tariff contracts, in contrast to

wholesale price contracts, do not result into double marginalization and they maximize

the vertical chain’s profits. Postmerger, firms trade through two-part tariffs only when

products are not too close substitutes. Otherwise, they trade through both contract types.

Under trading through two-part tariffs, the upstream firm(s) subsidize the downstream

production. Premerger, subsidization occurs because each upstream firm wishes to make

its downstream customer more aggressive. Postmerger, subsidization is due to the up-

stream monopolist’s “commitment problem.” As products get closer, substitutes and

downstream competition increases, the “commitment problem” gets more severe, and

the merged firm switches to trading through both contract types.

We also find that an upstream merger can have two distinct efficiency gains: It

increases the R&D investments, and thus, the upstream cost-efficiency, and decreases

the wholesale prices. This occurs as long as downstream competition is not too strongand

R&D investments are not too specific. The merger’s positive impact on R&D investments

is mainly driven by the fact that when R&D investments are not too specific, they reduce

2. These two contracts types are commonly used in the vertical relations literature and they are also

commonly used by firms (for empirical evidence see e.g., Smith and Thanassoulis, 2009, and Bonnet and

Dubois, 2010). To the best of our knowledge, Gal-Or (1991), Rey and Stiglitz (1995), Milliou and Petrakis

(2007), and Milliou et al. (2009) are the only papers that endogenize the contract types. These papers, with

the exception of Milliou et al. (2009), restrict the contract types choice to that among these two contract types.

Milliou et al. (2009), in a setting without upstream mergersand R &D investments, consider also price–quantity

bundle contracts, which specify the total input quantity and its total price. In Section 6,webrieflydiscuss

what happens under such contracts.