Do Vertical Mergers Facilitate Upstream Collusion? Second Version

We investigate the impact of vertical mergers on upstream firms' ability to sustain tacit collusion in a repeated game. We identify several effects and show that the net effect of vertical integration is to facilitate collusion. Most importantly, vertical mergers facilitate collusion through the operation of an outlets effect: cheating unintegrated firms can no longer profitably sell to the downstream affiliates of their integrated rivals. However, vertical integration also gives rise to an opposing punishment effect: it is typically more difficult to punish an integrated structure, so that integrated firms are able to make more profits in the punishment phase than unintegrated upstream firms. When downstream firms can condition their prices or quantities on upstream firms' contract offers, two additional effects arise, both of which further facilitate upstream collusion. First, an unintegrated upstream firm's deviation profits are reduced by the reaction effect which arises since the downstream unit of the integrated firm will now react aggressively to upstream deviations. Second, an integrated firm's deviation profit is reduced by the lack-of-commitment effect as it cannot commit to its own downstream price when deviating upstream.