Countervailing power and input pricing : When is a waterbed effect likely ?

A downstream firm with countervailing power can extract a reduced price from an input supplier. A waterbed effect occurs if this price reduction leads the input supplier to raise the price that it charges another downstream firm. Policy makers have been concerned that this waterbed effect could undermine downstream competition, and it was considered in detail in the 2008 UK grocery inquiry. This paper presents a simple but parsimonious model to investigate if and when a waterbed effect may arise. It shows that the effect may arise through optimal pricing behaviour, but that this critically depends on the nature of upstream technology, downstream competition and consumer demand. In particular, downstream competition tends to work against a waterbed effect, but convex upstream costs support the effect. The analysis is complementary to recent academic work on the waterbed effect that focuses on bargaining constraints. 1 Department of Economics, Monash University, Caulfield East, Victoria, Australia; E-mail: [email protected] I would like to thank Y.K.Ng for comments on an earlier draft of this paper. © 2012 Stephen P. King All rights reserved. No part of this paper may be reproduced in any form, or stored in a retrieval system, without the prior written permission of the author. The waterbed effect 1