Growth Strategy of a Firm via Mergers in Complementary Markets

Abstract

This paper examines the merger decision of a firm in a complementary market setting. There are two downstream firms which produce a base product and two downstream firms which produce side products that support a base product. The downstream firms commits to a compatibility contract with a complementary upstream firm. After the compatibility contracts are determined, the upstream firms must decide on a firm specific R\&D investment to supply a variety of side products for their complementary downstream firms. I map each different market schemes, which are characterized by the upstream firms' production efficiencies, to a merger type. I identify the conditions under which firms undergo vertical integration or a horizontal merger. Although an integrated firm invests less for its downstream competitor, the independent downstream firm might agree to a compatibility contract with the integrated firm in order to reduce the downstream competition effect when the integrated firm is efficient enough. As a result, the integrated firm acquires the business of its downstream competitor and underinvestment occurs in the market. The analysis shows that the likelihood of vertical integration increases as upstream firms' efficiency gap increases. However, the likelihood of vertical integration may or may not increase with the degree of downstream competition in the market. Unlike the predictions of two-firm models, vertical integration can be unprofitable because of the enclosure costs. This result can explain why any firm would not initiate a merger or an acquisition in a complementary market setting.