Vertical Integration and Bargaining: Linear vs Two-part tariffs

Abstract

We examine the implications of different contractual forms for welfare as well as for firms’ profits in a framework in which a vertically integrated firm sells its good to an independent downstream firm. Under downstream Bertrand competition, the standard result of the desirability of two-part tariffs over linear contracts in terms of welfare may be reversed. We obtain that the linear contract can generate higher consumer surplus and welfare than the two-part tariff when the independent downstream firm is rather powerful in determining the contract terms. In that case, the fixed fee is negative and the integrated firm makes more profits under a linear contract than under a two-part tariff. These results do not remain robust under downstream Cournot competition. Irrespective of the mode of downstream competition, the preferred contract type of the integrated firm is always welfare superior.

Keywords: vertical integration, linear contracts, two-part tariffs, bargaining

JEL Classification: D43, L13, L14, L22, L42, L81