This paper studies competition in a network industry with a stylized two layered network structure, and examines: (i) price and connectivity incentives of the upstream netwoks, and (ii) incentives for vertical integration between an upstream network provider and a downstream firm. The main result of this paper is that vertical integration occurs only if the initial installed-base difference between the upstream networks is sufficiently small, and in that case, industry is configured with two vertically integrated networks with neither of the upstream firm having an incentive to degrade the quality of interconnection. When the installed-base difference is sufficiently large, there is no integration in the industry, and the equilibrium quality of interconnection is lower compared to the equilibrium with two vertically integrated firms.
