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/.