Partial Vertical Ownership, Capacity Investment and Information Exchange in a Supply Chain

Partial vertical ownership describes a situation in which a firm holds financial shares in either its supplier (referred to as partial backward integration) or its customer (partial forward integration). We study the effect of such financial interconnectedness on two operational decisions: capacity investment and information exchange. In our model, a retailer, who has superior information about the future market demand, has passive financial holdings in the supplier. Although this passive financial investment does not enable the retailer to directly influence the supplier’s operational decisions, it does affect the market equilibrium. Specifically, financial interconnectedness between the firms can result in the retailer financing the entire capacity in the market. In addition, we characterize the conditions that ensure that information between the retailer and the supplier can be exchanged via cheap-talk communication. Interestingly, high level of information asymmetry facilitates the exchange of information via cheap-talk in the presence of these financial links. When cheap talk is not possible, we study the separating equilibrium that is achieved through the retailer’s commitment to order in advance. In this case, the separating quantity can either increase or decrease with the level partial vertical ownership, and this trend does not depend the actual level of the financial holdings. We further analyze the incentive of the retailer to conceal demand information by choosing a pooling equilibrium, and conclude with discussing the effect of the financial interconnectedness on the parties’ operational payoffs.