Tuesday, October 26, 2010
Posted by D. Daniel Sokol
Richard Ruble (EMLYON & CNRS, GATE), Bruno Versaevel (EMLYON & CNRS, GATE), and Étienne de Villemeur (Toulouse School of Economics (IDEI & GREMAQ)) describe Timing Vertical Relationships.
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 osets the ve! rtical externality, and this leader invests at the optimal market threshold.