The Incentive for Vertical Integration

This paper evaluates the incentive of firms to vertically integrate in asimple 2X2 Bertrand model of two substitutes that are each comprised oftwo complementary components. It confirms that all prices fall as aresult of a vertical merger. Further, we find that, when the compositegoods are poor substitutes, producers of complementary components arebetter off after integration. Thus, at equilibrium, each pair ofcomplementary goods is produced by a single firm (parallel verticalintegration). In contrast, when the composite goods are closesubstitutes, vertical integration reduces profits of the merging firmsand is therefore undesirable. Thus, at equilibrium, all four productsare produced by independent firms (independent ownership). The reasonfor the change in the direction of the incentive to merge is that, asthe composite goods become closer substitutes, competition between themreduces prices (in comparison to full monopoly) thereby eliminating theusefulness of a vertical merger in accomplishing the same price effect.We also find that, for intermediate levels of substitution, firmsproducing complementary components prefer to merge only if thesubstitute good is produced by an integrated firm. Thus, forintermediate levels of substitution, both parallel vertical integrationand independent ownership are equilibria. When the demand system issymmetric, total surplus is higher in parallel vertical integration, forall degrees of substitution among the products, even for the case whenthe goods are close substitutes and parallel vertical integration is notthe equilibrium outcome. Thus, the market provides less verticalintegration than is optimal from a social surplus maximizing point of view.