Does Vertical Separation Necessarily Reduce Quality Discrimination and Increase Welfare?

Abstract We investigate whether vertical separation reduces quality discrimination and increases welfare. Consider an industry consisting of a vertically integrated firm, the incumbent, and an independent retailer, the entrant, which requires access to the services of the incumbent's wholesaler. The wholesaler can discriminate against either of the retailers by supplying it an input of lower quality than its rival. We show that, in our setting, vertical separation of the incumbent reduces discrimination against the entrant's retailer, although it does not guarantee non-discrimination. Furthermore, with vertical separation, the wholesaler may discriminate against the incumbent's retailer. Vertical separation impacts social welfare through two effects. First, through the double-marginalization effect, which is negative. Second, through the quality degradation effect, which can be positive or negative. Hence, the net welfare impact of vertical separation is negative or potentially ambiguous.