Vertical Enclosure: Vertical Integration and the Reluctance to Purchase from a Competitor

Abstract

Vertical integration can reduce integrating firms' trading opportunities and, contrary to predictions of two‐firm models, this loss of trade can make integration unprofitable. If downstream units must commit to suppliers before contracting on the final terms of trade, then suppliers will have ex‐post monopoly power. This monopoly power reduces the quality that an integrated supplier will provide to its competitors. Expectations of this quality reduction can prevent firms from purchasing from an integrated supplier even though the supplier would be better off if it could commit to provide its downstream competitors with sufficient quality to retain their business.