Vertical Enclosure: Vertical Integration and the Reluctance to Purchase from a Competitor

Abstract

Vertical integration can reduce integrating firms' trading opportunities and, contrary to predictions of two-firm models, this loss of trade can make integration unprofitable. If downstream units must commit to suppliers before contracting on the final terms of trade, then suppliers will have ex-post monopoly power. This monopoly power reduces the quality that an integrated supplier will provide to its competitors. Expectations of this quality reduction can prevent firms from purchasing from an integrated supplier even though the supplier would be better off if it could commit to provide its downstream competitors with sufficient quality to retain their business.

Outsourcing, vertical integration, and price vs. quantity competition

“…Residual rights of control are not an issue in the simple game analyzed here because all relevant industry information is common knowledge and there are no contracting frictions. Bolton and Whinston (1993) and Heavner (2004), among others, provide interesting analyses of vertical integration in which non-trivial residual control rights arise. 4 A double marginalization problem arises when a retailer pays more for an input than the supplier's marginal cost of production and then raises its retail price above its own (already inflated) marginal cost of production to a level that is higher than that which maximizes the joint profits of the retailer and the supplier.…”

Outsourcing induced by strategic competition

“…Another line of argument in favor of outsourcing runs as follows. A vertically integrated provider, which competes in the final product market, will have incentive to "hold up" its supply once investments have been sunk in the procurement process (Heavner, 2004). Furthermore there is the considerable risk that the business plans of the input-seeking firm will get revealed to its rival via the orders placed.…”

Strategic Outsourcing under Economies of Scale

“…There is a large literature that considers various strategic aspects of sourcing (see, e.g., Cachon and Harker (2002), Shy and Stenbacka (2003), Chen et al (2004), Heavner (2004), Chen (2005), Buehler and Haucap (2006), Arya et al (2008a,b), Chen et al (2009)). The paper most closely related to ours is Chen (2005), who argues that an integrated firm might have incentive to disintegrate in order to better exploit scale economies.…”