Double Markups, Information, and Vertical Mergers

Abstract

In vertical contracting models with complete information and linear prices, double markups that arise between independent firms provide an efficiency rationale for vertical mergers since these eliminate double markups (EDM). However, the double markups vanish even without vertical integration if the firms are allowed to use two-part tariffs. Hence, the efficiency rationale for vertical mergers in models of complete information requires restrictions on the contracts that firms can use. In a sense, with complete information, two-part tariffs are simply too powerful. If instead one allows incomplete information and removes the restriction on contract forms, then vertical mergers continue to have an effect that is analogous to EDM, but they also have the potential to affect the overall efficiency of the market to the detriment of society. Consequently, the social surplus effects of vertical integration depend on the underlying market structure, and vertical mergers are, in and of themselves, neither good nor bad. We illustrate through an example that with incomplete information, the private benefits from vertical integration tend to be excessive; that is, vertical mergers remain profitable even when they are socially harmful.