lecture_9_tab - Costs and benefits of choosing between...

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ECOS3003 Lecture 9 1 Costs and benefits of choosing between alternative firm sizes What should a firm make and what should a firm buy? - integrate backwards or upstream: a firm that begins to make its own inputs - forwards or downstream integration: additional finishing or marketing etc In reality, there can be a continuum of options between: - spot markets - long-term contracts - vertical integration
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ECOS3003 Lecture 9 2 Vertical and Horizontal integration Strategic reasons - Chicago School – mergers efficient - could be that vertically integration to avoid double mark-up Example:
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ECOS3003 Lecture 9 3
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ECOS3003 Lecture 9 4
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ECOS3003 Lecture 9 5 Merger a way to overcome problem (although care needed setting transfer price) But problem here is that we have restricted type of contract two firms can write with one another - what about a two-part tariff? A sells input to B at MC (of $5000) and charges a fixed fee (of $6.25m) - vertical integration not needed to overcome double-marginalisation problem
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ECOS3003 Lecture 9 6 Market power - vertical integration used to extend/maintain market power Example: two markets – pain relief and cancer drug - DryCo has input required for both drugs - pain reliever market competitive - no close substitute for cancer drug - MC = $10 for input - drug company can turn 1 gram of input into either pain reliever or cancer drug Demand: Pain relief Cancer P = 100 – 5Q P = 200 – 10Q
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ECOS3003 Lecture 9 7 DryCo sets MR = MC However, manufacturers will engage in arbitrage: buy at $55 and resell to those making cancer drug for < $105 - to avoid this, DryCo can integrate forward and manufacture pain reliever - price pain reliever at $55 in retail market and sell input at $105 in wholesale market - arbitrage no longer possible Note: integration forward into the cancer market does not work: must integrate lower-prices (more elastic) pain-reliever market
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ECOS3003 Lecture 9 8 Why do firms exist? - make or buy decision
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This note was uploaded on 12/02/2009 for the course ECOS a taught by Professor A during the Three '09 term at University of Sydney.

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lecture_9_tab - Costs and benefits of choosing between...

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