Strategic Economics

Vertical Foreclosure and Raising Rivals' Costs

You do not have to be cheaper than your rival if you can make your rival more expensive. Learn the exact condition under which that strategy pays, why the Chicago School spent thirty years arguing it never could, and the assumption whose failure brought it back.

  • Expert
  • 16 min total
  • 15 chapters

What decision this helps you make: Whether a supplier, distributor, or platform that has just acquired one of your competitors can profitably squeeze you — and on the other side, whether an integration you are contemplating creates a real efficiency or only the appearance of one.

What this topic is

Vertical foreclosure is what happens when a firm that controls one stage of a supply chain uses that position against competitors at another stage: refusing to supply them, supplying them on worse terms, or withdrawing as their customer. Raising rivals' costs is the general strategy behind it. You do not need to be more efficient than a competitor if you can make the competitor more expensive, because the market price rises and you collect on every unit you sell.

Why it matters

This is the mechanism behind most of the disputes people actually live through: the component supplier that buys your competitor, the distributor that launches its own brand, the marketplace that starts selling the category you built on it. It is also the hardest case in competition economics, because vertical integration genuinely does create an efficiency — the elimination of double marginalization — and that efficiency lowers prices at exactly the same time the foreclosure raises them. Any analysis that only finds one of the two effects has not finished.

Who should learn it

Anyone whose cost base runs through a supplier that could integrate forwards, anyone whose distribution runs through a platform that could integrate backwards, corporate-development teams evaluating a vertical acquisition, and readers who want to understand why competition authorities treat these deals so differently from horizontal ones.

What you will understand

  • The exact profitability condition: recapture rate times downstream margin against the upstream margin given up
  • The single monopoly profit theorem, the four assumptions it rests on, and which of them fail in practice
  • Why an integrated firm can commit to things an unintegrated one cannot, and why that commitment is the source of the harm
  • Elimination of double marginalization — the offsetting efficiency that makes these cases genuinely hard

Prerequisites

Common misconception

That foreclosure is obviously irrational because a supplier makes money selling to everyone. That objection is the single monopoly profit theorem, it was the mainstream view for three decades, and it is correct under its own assumptions: if the input is used in fixed proportions, the downstream market is competitive, and the upstream firm can commit to its input price, then all the rent is already collectable through that price and foreclosing adds nothing. Every one of those assumptions fails routinely. The one that fails most interestingly is commitment: an unintegrated supplier cannot promise one customer that it will not supply the next one on better terms, and it therefore competes away its own monopoly rent. Integration solves that problem for the supplier, which is precisely why it can raise prices.