On the Benefits of Contractual Inefficiency in Quality-Differentiated Markets

Contractual inefficiencies within supply chains increase an input price above its marginal cost, therefore they are considered detrimental to consumer surplus. We argue that such inefficiencies may be beneficial to consumers in quality-differentiated markets where the "finiteness property" holds. Indeed, enhancing efficiency in high-quality supply chains through vertical integration may adversely affect the market structure by driving low-quality chains out of the market, and, consequently reduce consumer surplus. Due to the finiteness property, (counter-)integration in the low-quality channel does not allow this channel to be in business. Our result holds both with secret and public contracts, and with buyer power