Vertical integration and product differentiation

We study horizontal product differentiation as a strategic decision of downstream firms facing a threat of vertical integration and market foreclosure by an upstream monopolist. We model product differentiation either as pure market segmentation or as generating positive value to consumers. Because of the threat of vertical integration, the downstream firms prefer more differentiation when the latter merely yields the anticompetitive effects of market segmentation, while they may prefer less differentiation when the latter would generate additional social value. Therefore, instead of market foreclosure, we indicate market segmentation or under-investment in socially valuable activities, such as product innovation, design, and informative advertising, as possible social costs of a lenient antitrust policy towards vertical mergers.