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Partnerships and mergers when size matters

Abstract: In several industries downstream competitors form upstream partnerships. An important rationale is that higher aggregate upstream volume might generate efficiencies that reduce costs. In this paper we show that it might be better for two firms to form a partnership and compete downstream than to merge. Somewhat paradoxically, this is true if firms compete fiercely in the downstream market with a third firm. The reason is that a merger is de facto a commitment to set higher prices. Under aggressive competition from the third firm, the members will not want to make such a commitment when upstream marginal costs are decreasing in output.