Countervailing Power and Input Pricing: When is a Waterbed Effect Likely?

24 Pages Posted: 26 Apr 2012

See all articles by Stephen P. King

Stephen P. King

Monash University - Department of Economics; Productivity Commission

Date Written: April 24, 2012


A downstream firm with countervailing power can extract a reduced price from an input supplier. A waterbed effect occurs if this price reduction leads the input supplier to raise the price that it charges another downstream firm. Policy makers have been concerned that this waterbed effect could undermine downstream competition, and it was considered in detail in the 2008 UK grocery inquiry. This paper presents a simple but parsimonious model to investigate if and when a waterbed effect may arise. It shows that the effect may arise through optimal pricing behaviour, but that this critically depends on the nature of upstream technology, downstream competition and consumer demand. In particular, downstream competition tends to work against a waterbed effect, but convex upstream costs support the effect. The analysis is complementary to recent academic work on the waterbed effect that focuses on bargaining constraints.

Suggested Citation

King, Stephen Peter, Countervailing Power and Input Pricing: When is a Waterbed Effect Likely? (April 24, 2012). Available at SSRN: or

Stephen Peter King (Contact Author)

Monash University - Department of Economics ( email )

23 Innovation Walk
Wellington Road
Clayton, Victoria 3800

Productivity Commission ( email )

Level 28
35 Collins St.
Melbourne, Victoria, Victoria 3000

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