Equilibrium Vertical Integration with Complementary Input Markets

Abstract We provide a model to investigate vertical integration decisions. This model assumes that local downstream manufacturers require two inputs to make their final products. One input is produced by a supplier shared by both manufacturers; another is produced by an exclusive supplier for each manufacturer. We show that vertical integration of each downstream firm with its exclusive supplier enhances the input demand for the common supplier, leading to an increase in the common supplier's input price due to the elimination of the double marginalization. Moreover, downstream firms that require a smaller quantity of inputs from the common supplier, for instance, those with efficient production technology or smaller downstream demand, are more likely to vertically integrate because vertical integration yields a smaller increase in input price. Thus, the cause of firm-size heterogeneity is important to consider when investigating the relationship between firm size and the tendency to vertically integrate.