Investment Timing and Vertical Relationships
Etienne Billette de Villemeur
University of Lille I - EQUIPPE
Richard R Ruble
EM Lyon (Ecole de Management de Lyon)
Bruno P. A. Versaevel
EM LYON (Ecole de Management de Lyon)
March 15, 2013
GATE Working Paper No. 1118
We show that the standard analysis of vertical relationships transposes directly to investment dynamics. Thus, when a firm undertaking a project requires an outside supplier (e.g., an equipment manufacturer) to provide it with a discrete input to serve a growing but uncertain demand, 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-type index. Despite the underlying investment option, greater volatility can result in a lower value for both firms. We examine several contractual alternatives to induce efficient timing, a novel vertical restraint being for the upstream to sell a call option on the input. We also extend the model to allow for downstream duopoly. When downstream firms are engaged in a preemption race, the upstream firm sells the input to the first investor at a discount such that the race to preempt exactly offsets the vertical distortion, and this leader invests at the optimal time. These results are illustrated with a case study drawn from the pharmaceutical industry.
Number of Pages in PDF File: 41
Keywords: irreversible investment, preemption, real options, vertical relations
JEL Classification: C73, D43, D92, L13working papers series
Date posted: April 15, 2011 ; Last revised: April 27, 2013
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