Merge and Compete: Strategic Incentives To Vertical Integration

Vertical integration followed by quantity competition is studied. The downstream firms simultaneously decide whether to integrate with one of the upstream suppliers. If firms are not able to observe whether the vertically integrated competitor enters the intermediate good market, they are indifferent about vertical integration. However, if it is possible to observe the entry choice of the vertically integrated entity, the unique equilibrium involves vertical integration and in- house production of the intermediate good. The importance of entry's observability sheds light on the strategic importance of information exchange institutions such as the internet and business fairs.