Vertical Integration under an Optimal Tax Policy: a Consumer Surplus Detrimental Result

It is widely believed that vertical integration in an environment without foreclosure, or more generally without any mechanism that restricts competition among firms, raises the welfare of consumers. In this paper we show that this can be overturned in a standard setting. We consider a vertical structure where each downstream firm purchases an input from its exclusive upstream supplier in the presence of a welfare maximizing government which taxes/subsidizes the product of the downstream market. We show that a single or multiple vertical integrations alter the optimal governmental policy in a way that hurts consumers: integration induces the government to reduce the optimal subsidy and, as a result, industry output and consumer welfare decline.