Reference

Richard Ruble, Bruno Versaevel, and Étienne de Villemeur, “On the Timing of Vertical Relationships”, IDEI Working Paper, n. 627, June 23, 2010, revised April 11, 2011.

Abstract

We show that the standard analysis of vertical relationships transposes directly to investment timing. Thus, when a firm undertaking a project requires an outside supplier (e.g. an equipment manufacturer) to provide it with a discrete input, and if the supplier has market power, investment occurs too late from an industry standpoint. The distortion in firm decisions is characterized by a Lerner index, which is related to the parameters of a stochastic downstream demand. When feasible, vertical restraints restore efficiency. For instance, the upstream firm can induce entry at the correct investment threshold by selling a call option on the input. Otherwise, competition may substitute for vertical restraints. In particular, if two firms are engaged in a preemption race downstream, the upstream firm sells the input to the first investor at a discount that is chosen in such a way that the race to preempt exactly offsets the vertical externality, and this leader invests at the optimal market threshold.

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