The Upstream Pass-Through Rate, Bargaining Power and the Magnitude of the Raising Rivals’ Costs (RRC) Effect

The raising rivals’ costs theory predicts that a vertical merger will create an incentive for the vertically integrated firm to increase input prices to downstream rivals. A simple formula exists to estimate the magnitude of this input price increase. This formula has played a central role in the regulatory evaluation of a number of important recent vertical mergers and is likely to continue to play an important role in the regulatory evaluation of future vertical mergers. The formula requires an estimate of the upstream pass-through rate. Calculation of the upstream pass-through rate is complicated by the fact that prices in many upstream markets are determined by bilateral negotiations, where bargaining power is split between both sides of the market. Thus the manner in which the division of bargaining power affects the upstream pass-through rate must be taken into account. This paper shows that the existing formula for estimating the upstream pass-through rate has some deficiencies and suggests two new formulas for estimating it—depending on the timing of the upstream and downstream pricing decisions.