This technical economics paper, which can be found here, argues that, in the context of vertical mergers, indirect network effects create a form of demand complementarity downstream that softens the anticompetitive effects of vertical integration. At the same time, vertical integration creates various sources of market power. How such market power is exerted, and its impact on competition, depends on how the integrated firm balances its price instruments to harness indirect network effects. This depends, in turn, on how each side of the market values the participation of users from the other side, or, in short, the structure of indirect network effects. The authors show, in particular, that there is no systematic correlation between stronger upstream market power and foreclosure of competitors or consumer harm.
The paper is structured as follows:
Section II introduces a framework to analyse vertical integration with two-sided network effects.
The literature on vertical integration between an upstream input supplier and a downstream manufacturer has highlighted a trade-off between the efficiency gains brought by the merger and its potential negative impact on competition in the buyers’ market. Efficiency gains may come either from synergies created by the merger or from the removal of a double marginalization (that is, the integrated manufacturer is now able to get the input at a lower price). However, the integrated firm may also be able to charge non-integrated manufacturers a higher price for its input. This increased input price has two impacts: it makes the non-integrated manufacturer less efficient, which then tends to increase its downstream price; and it changes the pricing incentives of the integrated manufacturer. Overall, when the efficiency effect of vertical integration is sufficiently strong, both manufacturers’ prices decrease and the merger increases the surplus of buyers. When, by contrast, the anticompetitive effect of the merger is strong enough, both prices increase and the merger reduces the surplus of consumers.
The authors consider the effect that indirect network effects may have on this model. Consider operating systems providing an input to device manufactures. The larger the number of devices sold, the more interesting it is for developers to create applications for it; reciprocally, the larger the number of applications available on an operating system, the more interesting it is for a customer to buy a device running that operating system. The structure of indirect network effects relates to how much one side of the market (say, buyers) values the number of agents on the other side of the market (hence, application developers). Their strength relates to the compounding effect of these valuations. Under this framework, there are three different pricing instruments: (1) the prices charged by manufacturers to buyers for their devices; (2) the license fees set by platforms for the use of their operating systems by manufacturers; and (3) the developer fees charged by platforms to developers to make their applications available on their operating systems. Traditional models of vertical integration only take the first two prices into account; this updated model also takes into account price (3).
Section III evaluates the impact that taking into account the strength of indirect network effects has on traditional vertical integration models.
The first impact of indirect network effects is that they create a form of demand complementarity at the manufacturers’ level. If a device manufacturer lowers its prices, this will increase demand for devices overall. Thanks to indirect network effects, there will thus be more application developers for these devices, which increases the buyers’ demand for them. As a result, following the decrease of the price of a manufacturer of such devices, another manufacturer’s demand may increase despite its competitor’s prices having become lower, and that manufacturer may respond by increasing its own price.
Therefore, when indirect network effects are strong enough relative to the degree of substitutability between manufacturers’ devices (which is a proxy for the intensity of competition on the downstream market), manufacturers behave as if their products were demand complements (substitutes). This leads to a different competitive assessment of vertical integration, since in such a case there is never foreclosure of the non-integrated manufacturer (that is, its profit always increases with respect to the pre-merger situation) even though vertical integration still creates some market power and allow the integrated platform to increase its license fee beyond the pre-merger level. In a nutshell, indirect network effects tend to scale down the intensity of product market competition at the manufacturers’ level and antitrust authorities should be less concerned by the foreclosure effect of vertical integration when indirect network effects are strong.
However, when indirect network effects are strong enough, the merger may both benefit the non-integrated downstream competitor despite it paying a higher license fee, but it may harm final customers. One must therefore take into account the welfare effects of integration on the customers of the non-integrated downstream competitors.
Section IV does this by looking at the structure of indirect network effects.
The impact of indirect network effects can vary with the price of its source (e.g. app developer fees). With varying prices come differing effects. This raises the question of what is the socially optimal structure of prices. Clearly, licence fees should be set at the marginal cost of providing the operating systems. What about manufacturers’ prices and the fees charged on application developers? These prices should be set so as to harness the indirect network effects across both sides of the market, as it has been shown in the two-sided market literature. That literature also tends to support the idea that fierce competition between platforms prevents them from harnessing the indirect network effects between buyers and application developers. Some market power may restore that ability, thereby bringing the price structure closer to the one that would be socially optimal.
A vertically integrated firm will obtain some market power over non-integrated manufacturers. But, most importantly, the integrated firm now controls the pricing on both sides of the market, namely the price for its device and the fee paid by developers. Vertical integration creates a new source of market power because the integrated it creates monopoly power over the access to the buyers of its devices, thereby implying that application developers may be willing to pay in order to interact with those buyers. How this market power is exercised depends on the structure of indirect network effects (i.e. the value that one part of the market – e.g. developers – places on the other – i.e. device buyers – and vice-versa). The model shows that when indirect network effects are sufficiently asymmetric, vertical integration will benefit non-integrated manufacturers (even though the license fee increases), buyers, and application developers. When, by contrast, indirect network effects are weakly asymmetric, vertical integration leads to foreclosure and harms buyers.
In other words, a vertical merger that does not bring any efficiency gains (and creates some market power may paradoxically be cleared more easily than one that does not create market power in certain circumstances. A merger to market power may lead to an internalization of indirect network effects strong enough to benefit buyers, developers, and non-integrated competitors. Perhaps paradoxically, in platform markets, the market power created by the merger may actually be the basis of an efficiency defence.
This is one of those papers that I found both extremely interesting and unable to comment on because it is beyond my area of expertise. I would like to emphasise one point though: this model provides yet another example of how our intuitions and acquired habits regarding anticompetitive effects may not serve us well in multisided markets.