Block Ownership in Vertical Relationships in the Presence of Downstream Competition

Abstract

Firms sometimes acquire partial ownership of their upstream suppliers, which entails no direct control over the target firm’s decision-making. This paper studies the economic impacts of such partial vertical ownership (PVO) in a market with downstream competition, where a manufacturer supplies two competing retailers. We find that dividend payments between firms can alter firms’ incentives in their operational decisions and, hence, serve as an “invisible hand” to downstream competition and vertical interaction. We show that a higher PVO percentage can have both positive and negative effects because the acquiring retailer’s gain from PVO depends on not only its own sales but also the competitor’s sales. Thus, PVO has an inverted U-shaped effect on the acquiring retailer and the manufacturer’s total gain, which implies that an intermediate level of PVO percentage is preferred. Second, the relative strength of the positive and negative effects depends on the acquiring retailer’s competitive position. We show that the less competitive retailer can obtain more benefits from PVO than the more competitive retailer and, hence, the manufacturer prefers establishing PVO with the less competitive retailer. Lastly, consumers will benefit from the firms’ PVO relationship when the acquiring retailer is the more competitive retailer but may become worse off when the acquiring retailer is the less competitive retailer. Our research provides managers with some guidance on the optimal PVO relationship and policymakers with insights on regulating PVOs for consumer protection.