Vertical Mergers with Bilateral Contracting and Upstream and Downstream Investment

Abstract

We extend the theory of bilateral vertical contracting to a double moral hazard setting where upstream and downstream firms make complementary investments that enhance demand, downstream firms make fixed investments to enter the downstream market, and contracts are private information and determined through simultaneous bilateral bargaining. We show that vertical mergers mitigate bilateral contracting externalities and hold-up, which leads to an increase in complementary investments. If downstream products are either sufficiently distant or sufficiently close substitutes, a vertical merger benefits the merging firm, consumers, and the unintegrated downstream firm. For intermediate degrees of product differentiation, a case with linear demand and quadratic investment costs shows that consumers benefit if the marginal cost of investment is sufficiently low as revealed, for example, by a high ratio of R&D investments to sales. We apply the model to a vertical merger in the computer industry.

Keywords: Vertical mergers, Bilateral contracting externalities, Hold-up, Moral hazard

JEL Classification: D42, D86, L12, L42