Setting the stage
Most industries are characterised by the existence of several production and distribution levels. Inputs are combined and turned into outputs. An input can be a commodity (for example, coal, iron ore, cacao) or some infrastructure (for example, an aircraft stand at an airport, a railway station, a port). An input does not have to be a physical product or facility: it could be a patent, a license, some computer code or a database, for example. Further, in retailing, an input may even amount to an end-product: retailers buy a garment, an oven, a pack of cereals – which are inputs to them – before selling them on to end-consumers.
Although a product may involve several supply levels before reaching a final consumer (for example, sourcing raw materials, manufacturing, assembling, wholesale distribution, retail distribution), for the rest of the chapter, for simplicity, we will just assume that these vertical chains comprise two levels: one upstream and one downstream.
Further, in this chapter, we will focus on industries where there is just one (or very few) upstream suppliers. Economists sometimes refer to this situation as an ‘upstream bottleneck’. Natural monopolies may fall within this category.
Moreover, we will assume that the upstream monopolist is also active downstream, with its own affiliate (for example, the owner of a port also provides its own ferry services). Unless otherwise stated, we will refer to the incumbent as I, to its upstream affiliate asUI and to its downstream affiliate as DI. We assume that the incumbent faces a downstream rival, DR, which may already be in the market, or is considering entering. In the models we present in this chapter, we will mainly (with some exceptions) assume that this rival is as efficient as or more efficient than the incumbent. Figure 5.1 depicts this highly stylised industry.
This chapter will be mostly devoted to the discussion of how economic theory may explain possible conditions under which the incumbent would rather exclude a downstream competitor, leading to vertical foreclosure (or more simply to ‘foreclosure’). As we shall see, in most cases the incumbent would have the ability to exclude downstream rivals, but not the economic incentive to do so.