Entry‐Encouraging Vertical Integration

It is well established that a vertically integrated firm may have an incentive to raise its rivals' costs by increasing the wholesale price of inputs. We show that this incentive can lead vertical integration to facilitate entry into the downstream market: higher input costs weaken incumbent rivals, thereby improving the entrant's competitive position. Our framework considers an upstream firm that offers observable two‐part tariff contracts to downstream firms. The downstream market consists of two incumbents and one potential entrant, with competition modeled à la Cournot. In addition, downstream firms may also source inputs from an alternative, less efficient supplier. We fully characterize the conditions under which entry‐encouraging vertical integration is profitable and arises in equilibrium, and demonstrate that in most cases it enhances overall welfare. By contrast, we also identify a (small) region where vertical integration reduces the entrant's profits and deters entry. In such cases, vertical integration is always detrimental to welfare.