The economic analysis of product substitutability and intimidation effect on vertical integration

Abstract

This study applied the modified Cournot duopoly model proposed by Buehler and Schmutzler (2008) and Milliou and Pavlou (2013) to analyze and compare the economic efficiency of the separation model and vertical integration model. For the industry of downstream Research and Development (R&D), this model examines the effect of market size and product substitutability on the economic output. We establish the following results: (i) the benefits of a downstream firm on vertical integration will increase when the product substitutability is lower. (ii) While the market size becomes bigger, the benefit is further enhanced this conclusion. The integration firm will promote investment in R&D to cause intimidation effect. (iii) When the product substitutability is higher to a certain degree, the benefits will also increase. Thus, high degree of product homogeneity and high degree of product heterogeneity are more suitable for vertical integration. In the long run, the industry which will extend or increase in demand suggests a merger as early as possible.