Forward Integration by a Monopolist: Some Extensions

Vertical integration by imperfectly competitive firms poses both positive and normative economic questions. The positive questions concern the incentives of such firms to engage in forward or backward integration. On the other hand, the normative questions concern the impact of integration by such firms on social welfare. If the incentives of imperfectly competitive firms lead to a welfare gain, then there is no need for public intercession in the process, say, by antitrust authorities. However, if private incentives are at odds with social welfare, then public policy attention may be needed. These matters are considered in an extensive theoretical and empirical literature on vertical integration. A review of the central issues in this literature is provided by Machlup and Taber [5] and Warren-Boulton [12]. Here, I shall focus on the recent work by Schmalensee [8] and Warren-Boulton [11] on forward integration by a monopolist. The basic insight of their models is as follows. Suppose a monopolist is producing a product used as an input by a competitive downstream industry in variable proportions with another input. Monopoly pricing of the first input induces inefficient input utilization by the downstream industry in the production of the final good (the monopoly input price exceeds its marginal costs of production). The resulting efficiency loss represents an incentive for the monopolist to integrate forward. By producing the final product in an integrated firm, the monopolist transfer prices the otherwise monopolized input at marginal costs and thereby converts the efficiency loss into profit. This point was originally made by Burstein [3], but the recent work appears to have been motivated by the graphical formulation of Vernon and Graham [10]. After developing the case of a fixed proportions technology we present the Vernon and Graham illustration.