Abstract
We study incentives to vertically integrate in an industry with vertically differentiated downstream firms. Vertical integration by one of the firms increases production costs for the rival. Increased production costs negatively affects quality investment both by the integrated firm and the unintegrated rival. Quality investment by both firms decreases under any (vertical integration) scenario. The decrease in quality invesment by both firms softens competition among downstream firms. By integrating first, a firm always produces the high quality good and earns higher profits. A fully integrated industry, with increased product differentiation, is observed in equilibrium. Due to increase in firm profits, social welfare under this structure is greater than under no integration.
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