Mr Jamie

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Q3: An economic consultant advises a firm which is a monopolist in the production stage of an industry. He argues that this firm should take over the firm(s) at the successive retail stage. Explain the circumstances under which such a takeover raises the profits of the monopoly producer. Also, discuss why vertical integration might not increase the profits of the producer.

It is commonly believed that vertical integration is an attempt to create monopoly and to seek rents. Monopoly theories of vertical integration explain it as the instrument of price discrimination and the creation of entry barriers. Alternatively economic theory justifies integration on the grounds of efficiency achieved through greater economies of scale and scope resulting from mergers. (Chandler 1966). Chandler (1966) maintains, “when economies of scope between successive stages due to technological organizational interrelationships are strong enough, these activities should be provided under joint ownership, vertical integration has also been used to avoid factor distortions in monopolized markets “double marginilisation”. (Vernon and Graham 1971) (Schmalensee 1973). .

This essay outlines theoretical arguments of vertical integration including transaction costs, the level of double marginalization, the level of investment and associated hold up problems. Also reviewed are the ability to enable a monopoly to close gaps in incomplete contracts and enabling production decisions to adapt better to market conditions.Through discussing the various points it will enable the conclusion that despite vertical integration containing drawbacks, it is advantageous, “benefits of vertical integration slightly outweighing it’s costs” as vertical integration “increases profits through higher prices by creating barriers to entry” (Bain 1956;Salop &Scheffman 1983), as it will reduce costs through the economies the monopoly achieves from avoiding transaction costs and market exchanges, exploiting opportunities for coordinating external activities and creating power over buyers and suppliers (Harrigan 1983; Hennart 1988; Vicers and Waterson 1991). Increased profitability through operating together“ vertical integration can yield very significant profit improvements" (D’aveni&Ravenscraft 1994), as the integrated monopoly sets the profit maximising downstream monopoly price, properly taking into account the actual costs of production at the upstream level. Firstly vertical integration should be undertaken if there are lots of intercompany transfers to upstream or downstream lines of business, as it will reduce costs and increase profitability compared with the nonintegrated firms. It reduces transaction costs to the monopoly as vertical integration enables better management of business level managers, through corporate managers using vertical integration to harmonize incentives replacing profit maximization at individual stages with joint profit maximization.(D’ Aveni & Ravenscraft 1994). Secondly, a wide range of control instruments exist under vertical integration which can be used to solve problems arising from market transactions, e.g. legal costs of writing up transactions (D’ Aveni & Ravenscraft 1994).Thirdly, vertical integration enhances information exchange between successive stages of production. Reduced transaction costs are of particular importance in bilateral monopolies where there is hostile bargaining, when future uncertainties make long term contract expensive and when short term contracts are inefficient due to equipment becoming obsolete (Williamson 1975). Vertical integration should be pursued by the monopoly producer and therefore should take over the other firm at the successive retail stage, if that retailer is also a monopolist, as the chain monopoly will benefit from increased aggregate profits as the distortion from double marginalisation is reduced. Double marginalisation (Fig 1) occurs when an upstream monopoly has added...
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