Vertical foreclosure is a type of anti-competitive behavior. A company purchases a supplier that supplies both the company and several competitors with raw materials. The company then uses its leverage over the supplier to receive a discount when it buys raw materials, and reduces quantity and raises prices when its competitors buy raw materials.
Vertical foreclosure is most effective when the supplier has a monopoly. If there are several suppliers, manufacturers can purchase raw materials from the other suppliers. The manufacturer itself does not need to have a majority of market share to establish vertical foreclosure, especially if the supplier has a small value in comparison with the manufacturer.
Vertical foreclosure can create a vertical monopoly, in which one company controls every other company in the entire supply chain. The same company may own a logging business, a lumberyard, the furniture factory and a retail store. Anti-trust laws prohibit vertical foreclosure when it creates an illegal monopoly that harms consumers, but a vertical foreclosure that provides advantages to consumers is legal, according to the Stanford Institute for Public Policy Research.
Vertical foreclosure leads to inefficiency. The supplier may prefer to sell its products to many companies, so it can earn a higher profit because of the competing buyers. The supplier will also become dependent on the manufacturer that owns it, and risks going out of business if the manufacturer is struggling. Managers of the supplier will have worse performance statistics because of the discount the manufacturer receives.
Intangible assets can also be used to create a vertical foreclosure. In the pharmaceutical industry, research and development of new drugs depends on patents that a pharmaceutical company holds. A company can license its patents to many companies so they can make medicine. If one manufacturer buys out the company offering the licenses, the manufacturer can stop licensing these patents to its competitors.
If there are competing suppliers, a vertical foreclosure also harms them. When the manufacturer purchases one supplier, it invests in the supplier it controls, instead of spending money on other suppliers' products. If other manufacturers also purchase suppliers to remain competitive, the total number of suppliers in the market decreases, because independent suppliers lack customers.
Vertical foreclosure can affect public health. A pharmacy benefits plan pays for specific medicines and treatments. If a drug company buys a pharmacy benefits plan, it can influence the plan managers to recommend medicine that the company manufactures. Another medicine, which the manufacturer doesn't produce, may be a better treatment for a patient.
- Institute for Advanced Study; Vertical Foreclosure and Specific Investments; Rachel E. Kranton, Deborah F. Minehart; January 2002 (PDF)
- Stanford Institute for Public Policy Research; The Conflict Over Vertical Foreclosure in Competition Policy and Intellectual Property Law; Roger G. Noll; March 2004 (PDF)
- University of Chicago; Cementing Relationships: Vertical Integration, Foreclosure, Productivity, and Prices; Ali Hortacsu, Chad Syverson; October 2006 (PDF)