Market performance implications of the transfer price rule

We model the impact of the transfer price rule (a constraint that requires the downstream division of a vertically-integrated firm to earn at least a normal rate of return on investment in the counterfactual case that it pays the same price as a nonintegrated firm for the essential input), rejected by the U.S. Supreme Court in Linkline, for the performance of markets in which an upstream firm provides an essential input to a downstream firm with which it may compete in the retail market by vertical integration. We allow for horizontal and vertical product differentiation in the final good market. The upstream firm's equilibrium distribution choice (between exclusion, dual distribution, or nonintegration) depends on relative product qualities. We characterize conditions under which the transfer price rule alters the upstream firm's equilibrium distribution choice, and develop conditions for the transfer price rule to improve market performance.nrpages: 30status: publishe