Post on 30-Mar-2023
PUBLIC ECONOMICS, LAW AND POLITICS
COMPETITION ECONOMICS AND LAW
COMPETITIVE EFFECT OF VERTICAL INTEGRATION
A CASE STUDY OF FUEL SECTOR IN AFGHANISTAN
By
Abdul Maruf Yawari
M-Nr: 3018981
Lüneburg, February 2014
Advisor: Prof. Dr.Thomas Wein
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This paper has been written as one of the requirements of the seminar of the 3rd
semester namely Competition Economics & Law. Particularly, this research paper is
allocated to Competition Economic and has written independently, since the project
that has been presented in the class was prepared independently.
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INDEX
INTRODUCTION ................................................................................................................ 4
1. CONCEPTUAL BACKGROUND OF VERTICAL INTEGRATION .......................... 5
1.1. RESTORING MONOPOLY POWER THEORY.......................................................................... 6
1.2. RAISING RIVALS‟ COST THEORY ....................................................................................... 8
1.3. FACILITATING COLLUSION THEORY .................................................................................. 9
2. THE AFGHAN FUEL SECTOR ................................................................................. 10
3. POLICY RECOMMENDATIONS & FINAL REMARKS ......................................... 11
REFERENCE LIST ........................................................................................................... 14
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INTRODUCTION
Vertical integration among the elements of supply chain involves not an easy contracting
arrangement, as there is a broadly vertical restraint. The producers, whole sellers, and retailers
could make such arrangements which could harm free competition. These arrangements could
contain nonlinear tariffs, resale price maintenance, and the assignment of exclusive territories.
From the economic perspective, two main streams of thought could emerge about vertical
integration. First perspective states; that since the market are competitive, the vertical integration
could be adopted if the joint profits are increased, thus, there must be a necessary gain in
efficiency. The second perspective emphasizes on the anti-competitive effect of this arrangement
which could lead to disclosure of competition on retailer, or wholesalers‟ levels (Rey and
Stiglitz, 1998).
The structure conduct performance upholds the later views and looks at vertical integration
suspiciously, since they worry about exclusionary practices which can foreclose other
competitors to enter in the market, thus facilitating the monopoly in the market. On the other
hand, Chicago School, founded in the 1960s and 1970s, adherents to the former view and explain
why vertical integration increases the economic efficiency. Williamson (apud Riordan, 2005)
mentions that there is third view somewhere in the middle between these two extreme views, so
called to hybrid view. This view identifies new efficiency rationales behind vertical integration,
whereas that firm with market power may misuse their market power and restricted the consumer
welfare. Vertical integration also raises continuously concern for antitrust policy regulation.
Moreover, vertical Integration raises a conflict for the economic regulation of industries (Stigler,
1971).
The goal of this research paper will be to review the economic literature on the competitive
effect of vertical integration. I argue that vertical integration can harm competition, because it
increases the market power of the firm. There are theories as premise which supports my
hypothesis namely, restoring monopoly power, raising rivals cost and facilitating collusion
theories. These theories are based on the Post-Chicago school, and have deep roots in
competition policy. Moreover, in order to further support my assumption, I will analyze fuel
sector of Afghanistan as a case study based on these aforementioned theories of vertical
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integration. On the other hand, in order to have comprehensive analysis, I will also analyze
theories which reject the assumption that vertically integration could harm the free competition.
Two of these theories are namely single monopoly profit and eliminating markup theories, will
be discussed in this paper. Finally, there will be policy recommendations for Afghani
government to prevent incompatible practices of vertically integrated firms which harm
competition in the market.
1. CONCEPTUAL BACKGROUND OF VERTICAL INTEGRATION
There is common ground for various definitions of vertical integration among its adherences.
When a company expands its business into different areas that are at different points at the same
level, vertical integration is more likely to happen. According to Riordan (1990:4) “vertical
integration is the organization of successive production within a single firm, a firm being an
entity that produces goods and service”. Greaver (1999) says that the degree which a firm owns
its upstream suppliers and downstream buyers is referred to as vertical integration. If the activity
expands to downstream this referred to as “forward integration” and if they activity of the firm
expand toward up this referred to as backward integration. Perry (1989) says that a firm could be
describe as vertically integrated if it contain two single outputs in which the entire output of
upstream or all the quantity of intermediate input used as part into the downstream process or
conversely all or part of the quantity of intermediate inputs of the downstream process is
obtained from all or part of the outputs of the “upstream” process.
The pressing issue in this back and ford processes of vertical integration is the elimination of
contractual or market exchange and the substitution of internal exchanges within the boundaries
of the firm. By contrast, if the upstream part of the firm sold its all outputs to other buyers and
the downstream part purchased all of this intermediate input from other supplier, we would not
describe this as being vertically integrated, if some of the input sold by the upstream was finally
resold to the downstream subsidiary. There would not be internal exchange only contractual or
market exchange; this is not vertical integration but vertical combination. Vertical integration
also means the ownership over the difference stages of production or distribution. In nutshell,
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when the concerns rises around investment, employment, production, distribution and all stages
of distribution and production , the vertical integrated firm would be very flexible in terms of
making pivotal and vital decision.
According to Grossman and Hart (apud Perry, 2006) vertical integration is the complete control
over the assets.
Perry (1989) states that the vertical integration can be formed in number of ways, such as vertical
integration occur in the time when the firm is established. Vertical expansion occurs as a result
of internal growth of the firm, or through establishing its own new subsidiary in the neighboring
stages. Vertical merger describes vertical integration which occurs through the acquisition of one
firm by another firm in both theoretical and empirical level. Therefore in the next chapter the
focus will be on theories as premise to support the hypothesis that vertically integration does
harm free competition which asserts that vertical integration can harm free competition in the
market.
1.1. Restoring Monopoly Power Theory
According to this version of the single monopoly profit theory, set the whole seller price above
its marginal cost in order to motivate the downstream monopoly outcome, thus fully extract the
monopoly profits. It‟s also possible that the upstream firms negotiate this contract with firm A of
the downstream competitors who committed to pay the fixed fee. Vertical integration could help
downstream firms to foreclosure market for other competitors and thus extract monopoly profit
from downstream firms (Rey and Tirole, 2003). The upstream firm still has an incentive to defect
the aforementioned downstream firm and makes deal with the downstream firm B with a lower
wholesaler price. By doing so, the upstream firm offers downstream firm B variable cost
advantage over its opponents. In exchange the downstream firm B will pay a higher fixed cost.
Once downstream firm B informs the he was cheated by the upstream firm, now the downstream
firm B will not be able to earn enough profit and this will leads to intense competition. Such
skepticism by the downstream industry lead to a lower wholesaler and push the situation more in
terms of more competitive downstream price this will, in turn, limits the capacity of upstream
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firm to extract monopoly profits with a two-part tariff (Hart and Tirole, 1990). Roirdan (2005)
argues that the main idea behind upstream profit is not to make any multilateral commitments. In
Hart and Tirole (1990) module the upstream firm faces situation of take it or leave it. If the
downstream firm makes take-it or leave-it contract, the probability that upstream firm makes
sweetheart contract is very low. Since the other downstream stream firm will have perfect
information and thus they take caution step. Even if contract offers are public, the downstream
firms that commit themselves for a long run could be defect anytime by rival who rejects the
initial offer and finally negotiate a sweetheart deals (Riordan, 2005).
The vertical integration provides the possibility for monopoly and can impair the competition in
the market. The possibility of vertical integration lies to the ratio of fraction of business done at
each successive level of activities in the field of business in which they conduct operation. If the
vertically integrated firms control a small fraction of output, it‟s usually ignored in discussion of
vertical relation. But when a vertically integrated cover a large fraction of substantial output, it‟s
more likely that investigation occurs. Since in this sense, the firms will have the market power
and therefore it‟s likely that vertically integrated firm abuse its power. When a business
enterprise possess monopoly power at one level of production or distribution, vertical integration
may enable the firms to extend their power to earlier or later level of production. Thus it can
favor themselves over its independent suppliers or customers without fear of competition. It‟s
more likely that the vertically integrated firm may also adopt price discrimination policy and
charges different price for the same goods and services the same as monopoly (Edwards, 1953).
On the other hand, advocates of Chicago school argue that vertically integration not only harms
competition but it also benefits competition. The Chicago school advocates the theory of the
single monopoly profit and argues if an upstream monopolist can use contract to extract fully
monopolist profit from downstream firm, then there is no role for vertical integration to utilize
from monopoly power to obtain any additional profit. If downstream firms are equally efficient,
then in this situation it‟s enough to consider a uniform price (Riordan, 2005).
Meyer and Wang (2011) argue that the striking effect of pro-competitive of vertical integration is
to eliminate pre-merger double marginalization. Double marginalization arises when downstream
and upstream firms have some market power and each markup the price above their marginal
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cost. Then the upstream sells the product with first level markup price to downstream firms and,
in turn, downstream firm sets second markup price above its marginal cost and finally the
consumer of final goods burn the cost. But if the upstream and downstream merge that the
marginal cost will be lower and the final consumers pay lower cost. That will leads to market
efficiency.
1.2. Raising Rivals’ Cost Theory
A vertically integrated firm might increase the rivals „cost by increasing the price of a scares
input. Through artificially increasing of its own demand for the scarce input, the vertically
integrated firm increases the price of the whole input, as a result the cost of its un-integrated
rivals increases. Vertical integration in this sense, higher input price impacts the costs of
integrated firm and its downstream competitor asymmetrically.
This cost strategy favors the downstream vertical integrated firm in the cost of raising artificial
price for its rivals, and thus finally will lead to exclude other rivals from the market or otherwise
reduces the supply of their final goods. The final consumers are harmed by higher downstream
Prices. When the dominant firm‟s output market share is higher relative to its market share, then
the net effect on economic efficiency is negative (Riordan, 1998). Norman (2010) argues that
raising rivals’ costs is profitable strategy for the oligopolistic firms. Raising rivals‟ costs is based
on fact that it‟s easier to compete with firms which are less efficient. If a firm production cost
drives up, it decreases the output and set higher price and the other firms in the market will
benefit from it as they can increase their market prices and shares. Cost raising strategy first of
all introduce by Salo and Scheffman (1983-1987) which also includes boycott and other
exclusionary behaviors. Their paper receives especial attention, since it establishes a connection
between vertical integration and foreclosure. Foreclosure means that a vertically integrated firm
step back from the input good market, that is, it stops supplying the input to nonintegrated
downstream firms.
OSS (apud Normann, 2010) argues that firms have an incentive in vertically integrated firm to
engage in such a foreclosure since they gain from raising-rivals‟ cost effect. Riordan (2005)
argues that if the upstream products are differentiated, then the upstream firm has restricted
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ability to steal business from the rival by setting small price cut, credibility. Thus, the vertically
integrated firm has a greater incentive indeed adopt the strategy of non-refusal. Conversely, if the
products are homogeneous, the competition might be unaffected by vertical integration, both
competitors and consumer burn not extra cost.
There are number of ways that vertically integrated firm can refuse to supply. First of all, by
building reputation for exclusive self-supply. Second, the upstream firm could also design its
product which is incompatible with products of vertically downstream firms. Third, the
downstream competitors might concern that the upstream supplier might supply less input or
reduce the quality of complementary services. Thus, distorted psychologically of vertically
integrated firm could disadvantage its upstream division, meanwhile the market power of the
upstream rivals increases (Riordan, 2005).
1.3. Facilitating Collusion Theory
Anti-trust regulatory authorities concern that the vertical integration might lead to collusion at
upstream and downstream levels. Generally, collusion can be reached through an agreement or
tacit collusion. The 1984 non-horizontal merger guideline of the U.S department of justice
remained concern about several theories of vertical integration. The upmost concern was that the
forward integration might increase the market power by raising barriers to entry.
A second concern war that the forward integration might facilitate collusion because it is easier
for an upstream firm to monitor retail price (DOJ, 1984). A third concern war the elimination of
disruptive buyers in a downstream market, if an upstream firm views sales to particular buyers as
sufficiently important. The mergers of such buyers with an upstream firm eliminate the
opponents, thus making easier for the upstream firm to collude. Chen and Riordan (2004) argue
that the vertical integration might pave the ground for effective cartelization of a downstream
industry through exclusive contracts. On the other hand, the advocates of vertical integration,
Chicago School use “permissive approach to vertical merger and regulation of vertically
integrated industries” (Riordan, 2005). Thus they argue that the vertical integration increase
efficiency. In order to prove their hypothesis they use different theories such as transaction cost
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theory, elimination markups theory and so on so forth (Meyer and Wang, 2011). However I
found these aforementioned theories are more convenient due to all these theories and deductive
reasoning. In the next chapter we will analyze the fuel sector in Afghanistan as case study to
show how vertical integration harms the competitions.
2. THE AFGHAN FUEL SECTOR AS CASE STUDY
Fuel is the essential commodity that consumes hugely in Afghanistan. In Kabul, 35% of city
electricity in worst condition is generated by diesel generators. Thus, all Kandahar‟s emergency
electricity is supplied through this way, which makes it amongst the most expensive electricity
per kilowatt in the world. Fuel importing sector could serve as a better example for vertical
integration. In Afghanistan the fuel market is dominated by a very small number of large players,
who may be politically connected. These importer firms are Inter-Asia, Ghazanfar Group Oil,
Kafayat and Afghan Petroleum. These aforementioned firms have built their own pump stations
in several areas in Afghanistan. As Greaver (1999) says that the degree which a firm owns its
upstream suppliers and downstream buyers is referred to as vertical integration. If the activity
expands to downstream this referred to as “forward integration” and if they activity of the firm
expand toward up this referred to as backward integration. Figure 1 illustrates that there are
forward and backward integration in fuel sector of Afghanistan namely forward integration
between pump station and street trader and backward integration between large and medium
importer and whole sellers. Not only that but also they own fuel market which is vertical
integration. As Hart and Grossman argue that vertical integration is the complete control over
assets, they have complete control over fuel in fuel sector.
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Figure 1: Fuel supply chain in Afghanistan
Source: Afghanistan Research and Evaluation Unit, 2005
Based on Restoring Monopoly Power, these aforementioned upstream firms negotiated the
contract with those of the downstream competitors who committed to pay the fixed fee. Thus,
this vertical integration helped downstream firms to foreclosure market for other competitors and
thus extracted monopoly profit from downstream firms. These firms also facilitated collusion
because there are proofs that they have signed agreements or at least tacitly agreed to make
collusion. It‟s easy for these main importers to monitor the retailer price (Peterson 2005). These
aforementioned firms also have increased the rivals „cost based on the raising rival cost theory
by increasing the price of a fuel in the market. Through artificially increasing of its own demand
for the scarce input, these vertically integrated firms increased the price of the whole fuel, as a
result the cost of its un-integrated rivals has increased. Vertical integration in this sense, higher
input price has impacted the costs of integrated firm and its downstream competitor
asymmetrically
Moreover, their cost strategy has favored the downstream vertical integrated fuel firms in the
cost of raising artificial price for its rivals, which has excluded other rivals from the market.
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POLICY RECOMMENDATIONS & FINAL REMARKS
I argued in this paper that vertical integration can harm free competition. To support this
assumption three theories as premise have been used namely, restoring monopoly power, raising
rivals cost and facilitating collusion theories. Moreover, the assumption of this paper has
furthered supported by analyzing fuel sector of Afghanistan as a case study based on three
aforementioned theories of vertical integration agreement.
In order to prevent the harmful practices of the involved firms in the vertically integrated fuel
sector of Afghanistan, the Afghani government should consider these following
recommendations:
First of all, as Article 101 of Treaty on the Functioning of the European Union States, that there
should be a principle to control anti-competitive behavior, Article 101 TFEU:
The following shall be prohibited as incompatible with the
internal market: all agreements between undertakings, decision
by association of undertaking and concerted practices which may
affect trade between member states (not in Afghanistan case) and
which have as their object or effect the prevention, restriction or
distortion of competition within internal market.
Secondly, the competition law in Afghanistan should protect consumer and small firms from
large aggregation of economic power, whether in form of monopolies or through agreements
whereby the other firms coordinate their steps to act as one joint monopoly.
Thirdly, the competition law of Afghanistan should prevent the abuse of market power by
dominate firms in the market of Afghanistan. Because based on Restoring monopoly power
theory these firms have misused from their market power and raised the price of fuel especially
in the winter season.
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Finally, the government should also consider outlawing every contract, amalgamation,
combination, hoarding, or conspiracy in restraint of trade, and monopolization and treated these
practices as violated acts. Afghanistan should follow the example of Sharman Act in the United
States in 1890s which sets the stage for a century of jurisprudence regarding monopoly, cartel,
and oligopoly. Last but not least, the Afghani government should adopt measures to protect the
market against hoarding, bid rigging and, other anti-competitive practices.
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REFERENCE LIST
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Marketing Association, Article Stable URL: http://www.jstor.org/stable/1247017, Vol. 17, No.4
Rey, P., & Stiglitz, J. (1988). Vertical restraints and producers' competition. European Economic
Review, 32(2), 561-568.
Vertical Integration and the Monopoly Problem, Accessed: 12/02/2014 09:41
Meyer, C.,S & Wang, Y.S, (2011) economic committee newsletter, determining the Competitive
Effects of Vertical Integration in Mergers Vol. 11, No. 1 10 Spring 2011
Riordan, Michael H. (1998). “Anticompetitive Vertical Integration by a Dominant Firm.”
American Economic Review, 88, 1232-1248.
Norman, Hans T. (2010) “Vertical Mergers, Foreclosure and Raising Rival Costs Experimental
Evidence.” Düsseldorf, Germany,
Stigler, George (1971). “The Theory of Economic Regulation.” Bell Journal of Economics,
71, 3-21.
Edwards, C. D. (1953). Vertical integration and the monopoly problem. The Journal of
Marketing, 404-410.
Riordan, M. H. (2005). Competitive effects of vertical integration.
Greaver, M. F. (1999). Strategic outsourcing: a structured approach to outsourcing decisions
and initiatives. AMACOM Div American Mgmt Assn.
Hart, Oliver, and Jean Tirole (1990). “Vertical Integration and Market Foreclosure.”
Brookings Papers on Economic Activity: Microeconomics, special issue, 205-276.
Rey, Patrick and Jean Tirole (2003). “A Primer on Foreclosure.” Forthcoming in the
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Handbook of Industrial Organization III, edited by Mark Armstrong and Robert Porter, Elsevier.
Perry, M. K. (1989). Vertical integration: determinants and effects. Handbook of industrial
organization, 1(4), 183-255.
Peterson, Ana (2005): Understanding Markets in Afghanistan. A study of the Market for
Petroleum Fuels. Available online at http://www.a-acc.org/files/.