Downstream mergers and entry

We consider an upstream firm selling an input to several downstream firms through observable two-part tariff contracts. Downstream firms can alternatively buy the input from a less efficient source of supply. We show that downstream mergers lead to lower wholesale prices. They translate into lower final prices only when the alternative supply is inefficient enough. Downstream mergers are very profitable in this setting and monopolization is the equilibrium outcome of a merger game even for unconcentrated markets. Finally, the expectation of monopolization stimulates wasteful entry of downstream firms in the industry, which calls for policy intervention.