Vertical Integration and Market Power in Supply Networks

Abstract

Vertical integration, a strategic approach where firms control multiple stages of production and distribution, offers potential operational efficiencies and market power. While the operations management literature emphasizes its benefits for supply chain coordination, reduced transaction costs, and risk mitigation from informational asymmetries, certain antitrust studies concern how vertical mergers may enable dominant firms to limit competition by creating entry barriers and causing input or market foreclosure. There is some evidence of the potential supply chain benefits of vertical integration across a few industries. However, empirical evidence on its anti-competitive effects remains scarce. This paper contributes to closing this gap by examining vertical integration's impact on firms' market power, as measured by their price-marginal cost markups. Our research investigates pre- and post-integration markups to determine whether firms gain anti-competitive market power after integration, diverging from competitive market pricing. Since firms' marginal costs are not usually observed in data, we estimate markups using production function estimations, following recent advances in empirical industrial organization. We compile a novel dataset on vertical integration cases using the FactSet Revere and the SDC platinum databases. Specifically, we identify 213 vertical mergers between firms with existing buyer-supplier relationships from 2003 to 2022. Methodologically, we employ a staggered difference-in-difference approach in conjunction with instrumental variables (constructed using mutual fund stock outflow events) that cause an exogenous variation in firms' decisions to integrate vertically. Our analysis reveals that vertical integration increases acquiring firms' markups by 13% and their rivals' markups by 12%. We also report a steady increase in post-integration markups since 2003, which suggests growing market power and industry concentration in the last two decades and implies a need for stricter antitrust enforcement. Interestingly, we find that the increase in firms' market power post-integration does not come from improved operational or cost efficiencies but rather from higher than competitive prices. Our paper offers causal evidence of vertical integration’s anti-competitive and welfare-reducing outcomes. The insights from our paper contribute to the ongoing operations and antitrust discussions and are relevant for high-profile vertical merger cases.