Vertical Control with Variable Proportions: Ownership Integration and Contractual Equivalents

Abstract

In an important, albeit somewhat neglected, article, Burstein [4] pointed out that an input monopolist may have an incentive for forward integration even when the downstream industry is competitively organized.' Specifically, when downstream firms are able to employ the monopolized input in variable proportions, the intermediate product monopolist has an incentive to vertically integrate forward. Burstein's contribution has been rediscovered, formalized, and extended in a more recent series of articles dealing with what has become known as the variable proportions incentive for vertical integration.2 The results derived in these articles are founded upon the use of ownership integration as the input monopolist's vertical control mechanism. This assumes that integration by ownership is a viable strategy for the upstream firm. In fact, however, there is some evidence that vertical integration may raise certain costs or risks that limit its usefulness as a tool for controlling the input decisions of firms at the downstream stage. At least three potential shortcomings of vertical integration have been raised in the literature. First, Smith [1 1] has shown that the per unit cost of capital to the firm may be an increasing function of the quantity of capital raised in the bond market. Therefore, ownership integration may significantly raise the firm's capital costs and, thereby, erode potential profits. Second, Shelton [10] has presented evidence that expansion of the firm's domain through forward integration may entail managerial diseconomies of scale that also reduce the profits attainable through the use of this strategy. And third, Schmalensee [9] has demonstrated that vertical integration will re-