Vertical Integration in Sequential Negotiations

Abstract

We study vertical integration in the form of financial ownership as a way to improve the bargaining position of a firm in sequential negotiations. In our model an upstream monopolist bargains sequentially with two downstream firms over production agreements. If the bargaining sequence is pre-determined, then integrating with one of the downstream firms helps the monopolist to extract more rents from the other firm, by raising his outside option in negotiations. If, on the other hand, the monopolist can choose his bargaining partner, then integration produces an additional effect: it serves as a commitment device of no return to the non-integrated firm after a breakdown of negotiations. This makes that firm more willing to settle today, and at higher price. These favorable effects, however, only realize if the downstream firms are strategic substitutes, and are reversed if they are complements. In the case when the principal is located downstream, and we find the surprising result that his expected profits are unaffected by vertical integration.

Keywords: vertical integration, bargaining, foreclosure

JEL Classification: C72, L42