An important issue in economics and antitrust policy is how vertical merger, or vertical integration, affects competition. Vertical merger refers to a situation in which an upstream supplier, such as an electronics company, merges with a downstream firm, such as a retail chain. In such circumstances the electronics firm may require that the retail outlets sell its products exclusively. The traditional foreclosure theory viewed vertical merger as harming competition by denying competitors access to either a supplier or a buyer. The foreclosure theory has received strong criticism from authors commonly associated with the Chicago School. The Chicago School view of antitrust emphasizes that the efficiencies generated by vertical integration are likely to result in lower prices to final consumers. A more recent strategic approach to the subject, which I have explored in my research, has shown how vertical integration might have the opposite purpose and effect.

The use of exclusive contracts by customers and suppliers in intermediate product markets is equally controversial. American courts and antitrust agencies have found many cases of exclusive dealings to illegally foreclose competition. The Chicago School disputes this finding, arguing instead that exclusive contracts are presumptively efficient, because it is usually unprofitable to foreclose competition via exclusive contracts. More recently, industrial organization economists have studied alternative models in which exclusive contracts can have the effects of foreclosing more profitable potential entrants.

The existing economics literature on vertical integration and exclusive contracts yields important insights on the competitive effects of these practices when they arise in isolation. However, available studies generally ignore the incentives for, and effects of, these practices when undertaken in combination. In a joint paper I wrote with Professor Michael Riordan of Columbia University, we uncover an unnoticed connection between exclusive contracts and vertical integration. This connection is motivated by the observation that in some intermediate product markets vertical integration and exclusive contracts exist simultaneously. For instance, in Standard Oil Co. v. U.S. (1949), Standard Oil sold about the same amount of gasoline through its own service stations as through independent retailers with which it had exclusive dealing contracts. In U.S. v. Microsoft (2000), Microsoft, which had vertically integrated into the internet services business, signed license agreements with competing online service providers, requiring them to promote and distribute Microsoft’s Internet Explorer to the exclusion of competing browsers.

The theory we develop in this research shows that this institutional feature is potentially important in understanding the incentives and effects of vertical mergers and exclusive contracts. More specifically, employing a game-theoretical model, we demonstrate that a vertically integrated upstream firm has the ability and incentive to use exclusive contracts to exclude equally efficient upstream competitors and control downstream prices. Neither exclusive dealing nor vertical integration alone has this anticompetitive effect.

We have presented this research at many institutions, including the Antitrust Division of the U.S. Department of Justice and over a dozen universities. One of the major difficulties in vertical merger analysis and antitrust enforcement is the lack of workable indicators of harmful vertical mergers. Our research has clearly identified circumstances where increased antitrust scrutiny would be warranted.

This research is closely related to my broader interest in the issue of competition and vertical organization. A basic premise of my research in this area has been that the vertical organization of firms affects, and is in turn affected by, their strategic decisions regarding horizontal competition. Horizontal competition refers simply to different firms selling similar products, as would be the case with competing electronics companies. As some of my recent work has shown, this approach offers interesting insights on various business practices, such as why manufacturers use resale price maintenance and other forms of vertical contractual restraints, why companies vertically disintegrate (as with AT&T’s divestiture of its equipment division), and why firms choose international outsourcing. Research in this area has also led to other interesting economic questions, one being how to model oligopoly competition among firms that are located in different areas. Working again with Michael Riordan, I have recently developed a new spatial model of differentiated oligopoly with geographically separated competition. We call this “spokes model,” and use it to analyze vertically related markets as well as to address some of the core economic questions that arise when firms engage in product differentiation.