Chapter 3 - VERTICAL INTEGRATION IN A DIFFERENTIATED DUOPOLY

Abstract

This chapter explores the kind of impact that product differentiation might have on the equilibrium outcomes and on the firm's vertical integration strategy, the equilibrium industrial vertical structure, and the social welfare as a whole. The introduction of product differentiation into a successive duopoly provides some new insights. The profits of merging firms and the whole industry are not always the highest under full vertical integration. When the final goods are substitutes and when degree of the product differentiation is low, vertical integration results in lower profits for the merging firms than what would be obtained under the vertical structure of supply contracts. It is because the level of competition between the rival firms with less differentiated products makes the cooperation less likely, and it dampens their profitability. However, when the products are highly differentiated, direct competition is of less concern for the rival firms, and economic efficiency can be increased by eliminating the double marginalization in the intermediate goods market. The relative profitability of vertical integration changes when the level of product differentiation varies. When the final goods are complements, vertical integration becomes the vertical structure, which produces the highest profit for the merging firms and for the industry as a whole.