Vertical Integration and Sabotage in Regulated Industries

Abstract

An essential facility produces 'access', an essential input used by a competitive downstream industry. The access charge is regulated. The essential facility can vertically integrate into the downstream segment and sabotage rivals increasing their costs. We systematically study the vertical integration decision and the optimal level of sabotage. Contrary to most of the literature, we allow for free entry into the downstream segment, so that prices equal long-run average costs. We find the following: First, sabotage does not pay when diseconomies of scope are large, or the subsidiary's market share is small. Second, when sabotage pays, and the subsidiary coexists with rivals in equilibrium, optimal sabotage increases with the subsidiary's market share and scope economies. On the other hand, when the essential facility optimally sabotages to exclude rivals, the intensity of sabotage falls with economies of scope. Third, unless the subsidiary is implausibly more efficient than independent firms, vertical integration never benefits consumers.