Optimal pricing behavior of vertically integrated utilities: The case of the italian IPEX

A classical result of the industrial economics literature postulates that vertically integrated firms do not exploit their potential market power in monopolistic or quasi-monopolistic markets. Vertically integrated firms are firms which act on different sides of the same market both being under the control of the same holding company. The upstream firm can be a producer or a seller while the downstream firm can be a distributor or a buyer of the good. When the upstream firm enjoys some market power profit maximization would require setting prices at a monopolistic level. In this manner high profits of the upstream  operator go at the expense of the downstream branch. The problem is particularly relevant in markets where the downstream activity is regulated like for example the electricity industry: distributors buy electricity in the wholesale market and sell it to consumers  under tight constraints on prices and tariffs. Applied researches in the field find that it is common for the upstream operator to take into account downstream profits and in so doing it does not maximize profits especially when the actual market conditions (for example, high demand hours) would allow price spikes. Other theoretical and applied papers take vertical integration for given and assume that the upstream firm maximizes joint profits (upstream and downstream) and more specifically it calculates optimal price/bid on the net residual quantity allocated in the wholesale market .

In the paper we endogenize the choice of the optimal strategy by explicitly modeling the behavior of managers (upstream and downstream) and the principal (holding). In the theoretical model the principal (holding company) has the incentive problem of inducing the upstream firm’s manager to take into account (part of) the profit of the downstream branch. In so doing the principal tries and redistributes profits between the two branches while the upstream agent derives utility from a monetary transfer paid by the principal and from the profit of the firm he manages. We derive conditions for the optimal pricing behavior of the upstream manager who finds optimal to take into account a part of the downstream profit (quantity).

We then conduct an empirical analysis of the model and we estimate what we call the “degree of vertical integration”. This is defined as the downstream quantity which the upstream manager includes in his maximization problem when setting the price. For the empirical part we use data from the Italian power exchange taking into account the vertical integrated dominant operator, ENEL, who acts on both sides of the market with ENEL Produzione (upstream) and ENEL Trade (downstream).

Authors:

Bruno Bosco*, Professor of Public Finance, University of Milan-Bicocca

Lucia Parisio*, Professor of Public Finance, University of Milan-Bicocca

Matteo Pelagatti*, Lecturer of Economic Statistics, University of Milan-Bicocca

* Department of Economics, quantitative Methods and firm Strategy (DEMS), Piazza dell’Ateneo Nuovo 1, 20126, Milan, ITALY

Corresponding Author:

Lucia Parisio (lucia.parisio@unimib.it) +390264484071

Keywords: regulation, vertical integration, competition, electricity markets, strategic delegation.

JEL classification code: L22, L43, L51, L94.

Focus : Micro, Industrial Organization.