Lessons from Foreclosure Parables: The Need to Tether Vertical Merger Analysis

Abstract

Policy authorities are pushing non-equilibrium arguments to challenge vertical mergers: if the merging upstream firm has a dominant market share but a low profit share, it has the power to foreclose and the incentive to do so because the cost of foreclosure is small relative to the gains. The flaw in this logic, analogous to flaws exposed in the Lucas Critique, is that the argument does not consider how rival suppliers and downstream buyers respond to the foreclosure attempt. Logically, a low upstream profit share is direct evidence that downstream buyers would respond to foreclosure by purchasing substantially less from the dominant supplier (presumably more from rivals), otherwise the dominant supplier would have raised the pre-merger price. We modify standard foreclosure analysis to account for these responses. Using equilibrium relationships, we “tether” the departure rate—the rate at which sales of foreclosed firms depart in response to foreclosure—to pre-merger observables. We use our approach to provide necessary and sufficient conditions for profitable foreclosure.

Keywords: Vertical Mergers, Vertical Integration, Foreclosure, Double Marginalization, Lucas Critique

JEL Classification: D01, D21, D40, D86, L42