Mr Jamie
Q3: An economic consultant advises a firm which is a monopolist in the production stage of an industry. He argues that this firm should take over the firm(s) at the successive retail stage. Explain the circumstances under which such a takeover raises the profits of the monopoly producer. Also, discuss why vertical integration might not increase the profits of the producer.
It is commonly believed that vertical integration is an attempt to create monopoly and to seek rents. Monopoly theories of vertical integration explain it as the instrument of price discrimination and the creation of entry barriers. Alternatively economic theory justifies integration on the grounds of efficiency achieved through greater economies of scale and scope resulting from mergers. (Chandler 1966). Chandler (1966) maintains, “when economies of scope between successive stages due to technological organizational interrelationships are strong enough, these activities should be provided under joint ownership, vertical integration has also been used to avoid factor distortions in monopolized markets “double marginilisation”. (Vernon and Graham 1971) (Schmalensee 1973).
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This essay outlines theoretical arguments of vertical integration including transaction costs, the level of double marginalization, the level of investment and associated hold up problems. Also reviewed are the ability to enable a monopoly to close gaps in incomplete contracts and enabling production decisions to adapt better to market conditions.Through discussing the various points it will enable the conclusion that despite vertical integration containing drawbacks, it is advantageous, “benefits of vertical integration slightly outweighing it’s costs” as vertical integration “increases profits through higher prices by creating barriers to entry” (Bain 1956;Salop &Scheffman 1983), as it will reduce costs through the economies the monopoly achieves from avoiding transaction costs and market exchanges, exploiting
It is commonly believed that vertical integration is an attempt to create monopoly and to seek rents. Monopoly theories of vertical integration explain it as the instrument of price discrimination and the creation of entry barriers. Alternatively economic theory justifies integration on the grounds of efficiency achieved through greater economies of scale and scope resulting from mergers. (Chandler 1966). Chandler (1966) maintains, “when economies of scope between successive stages due to technological organizational interrelationships are strong enough, these activities should be provided under joint ownership, vertical integration has also been used to avoid factor distortions in monopolized markets “double marginilisation”. (Vernon and Graham 1971) (Schmalensee 1973).
.
This essay outlines theoretical arguments of vertical integration including transaction costs, the level of double marginalization, the level of investment and associated hold up problems. Also reviewed are the ability to enable a monopoly to close gaps in incomplete contracts and enabling production decisions to adapt better to market conditions.Through discussing the various points it will enable the conclusion that despite vertical integration containing drawbacks, it is advantageous, “benefits of vertical integration slightly outweighing it’s costs” as vertical integration “increases profits through higher prices by creating barriers to entry” (Bain 1956;Salop &Scheffman 1983), as it will reduce costs through the economies the monopoly achieves from avoiding transaction costs and market exchanges, exploiting
References: Bain J. S (1956) “Barriers to new competition.”Cambridge M.A Harvard University press. Hart O &Tirole J (1990) “Vertical integration and Market foreclosure.”Massachusetts Institute of Technology, pp213-246. Harrigan, K R (1985) “Vertical integration and corporate strategy.”Academy of Management Journal. 28 397-425. Harrigan, K R (1983) “Strategies for vertical integration” Lexington, MA Health and Lexington books. Matthewson G F & Winter R A (1984) “An Economic theory of vertical integration” Journal of Economics. , 15, pp 27-38. Salop S C&Scheffman D T(1983) “Raising rivals costs.” American economic review” 73 267-271. Schmalensee, R. 1973. “A note on the theory of vertical integration,” Journal of Political Economy, 81 (March/April): 422-49 Williamson O E (1975) “Markets and hierarchy” : Analysis and antitrust implications New York free press. Josjow P L (2006) “Vertical Integration[online] Available at http://economics.mit.edu/files/1191” [Accessed 01 January 2013].