"Vertical" Integration and Foreclosure of Complementary Products

Using data from the 128 bit video game industry this paper evaluates the effect of vertical integration and the foreclosure of complementary software to rival hardware. Foreclosure occurs when a console hardware manufacturer produces software which is incompatible with rival hardware. Estimation of video game console demand deviates from previous research by incorporating video game heterogeneity and software competition into demand for consoles-consumers differentiate between games rather than assume video games are homogeneous. There are two important trade-offs to vertical integration. The fi…rst is a foreclosure effect which increases console market power and forces prices higher. The second, an efficiency effect, drives prices lower. Counterfactual exercises determine vertical integration with foreclosure is pro-competitive. It increases price competition as well as consumer welfare and console manufacturer pro…ts, and is due to console makers subsidizing consumers in order to increase video games sales, in particular their own developed games, where the greatest proportion of industry pro…ts are made.