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FRIENDS DO MATTER:

STRATEGIC UNCERTAINTY AND VERTICAL CONTRACTUAL RELATIONS*

ALBERTO COTTICA LISA DE PROPRIS GIOVANNI PONTI


UCL UNIVERSITY OF BIRMINGHAM UCL and ELSE

ABSTRACT

In the literature on vertical integration little attention has been paid to


the role of strategic uncertainty, that is, the presence of multiple self-
enforcing outcomes which might lead to coordination failure. However,
the natural solution to this problem, which is vertical integration, is not
the only way out if the agents have some degree of freedom in
designing the industrial relations they engage. A game-theoretic model
is provided to show how some of the most popular forms of vertical
contractual relations can be derived as equilibria of a multi-stage
game in which firms bargain over their reciprocal vertical control, in
order to minimize the inefficiency created by strategic uncertainty.

JEL CLASSIFICATION NUMBER : D23, D21


KEYWORDS: Industrial Organization, Vertical Integration, Game Theory
CORRESPONDING AUTHOR : Giovanni Ponti - Department of Economics - University of California
Santa Barbara, CA 93106-9210.
E-MAIL : g.ponti@ucl.ac.uk

* The authors are grateful to Titti Battagion, Patrizio Bianchi, Sebastiano Brusco, Vincenzo De NIcolò, Peter Sinclair and David
Ulph for suggestions and comments. Usual disclaimers apply.

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1. INTRODUCTION

Why cannot a collection of small firms do what a large firm does? Paraphrasing Williamson
[1985], who originally posed the question the other way round, we claim that vertical control
can be in many circumstances a suitable alternative to vertical integration. Market can work as
well as hierarchy, whenever the agents have some degree of freedom in designing the
contractual arrangements they engage.
According to Coase [1937], if transactions were costless, then the organisation of economic
activities would be indifferent between taking place either on the market or within the firm. .
The dichotomy between market and hierarchy as institutional arrangements, has been also
analyzed by Williamson [1975, 1985] by arguing that the internalisation of transactions within
the firm, as an institution embodying some authority, allows transaction costs to be greatly
reduced. The existence of firms as a vertically integrated institutions, where contracts are
internalised, is there explained in terms of transaction costs reduction compared with the case
where the same transaction was carried out in a purely decentralized setting. An additional
argument to endorse the thesis in favour of vertical integration comes from the theory of
property rights1, according to which ownership, and therefore vertical integration, matters
when contracts are incomplete, and it is therefore impossible for parties to specify all the
possible contingencies in the contractual agreement.
A good example of the methodology pursued by this line of research comes from Grossman
and Hart [1986]. In their model, ownership is defined by means of the control over the residual
property rights left unspecified by the (incomplete) contractual agreement. The “efficiency” of
the vertical relation is derived from the comparison between ex-post profits and ex-ante
decisions: integration is optimal when one firm’s strategic choice is particularly important
relative to the other firm’s (in terms of cumulative ex-post payoff) whereas non integration is
desirable when both choices are “...somewhat important...”.2
As in Williamson, in Grossman and Hart’s model firms face a dichotomic choice: they have to
decide whether to merge or not. However, the nature of economic transactions and the relative
response to the cost reduction issue has seemed to produce a wide range of institutional
arrangements in between market and hierarchy, which have mostly been neglected by the main
literature. Rather than exploring the spectrum of these intermediate solutions, the attention has
been focused on the dichotomy between these two extremes.
However, control can differ from ownership. The study of vertical contractual relations3 is
gaining reputation in the field by focusing on the alternative means by which independent firms
operating at successive stages along the production chain may decide to coordinate, up to a
certain extent, their actions as if they were parts of a unified structure. In those circumstances,
where integration is not the optimal option4, when properly characterised, vertical contractual

1 See Hart [1995] for a survey on this line of research.


2 See Grossman and Hart [1986], p. 717.
3 See, for example, Katz [1989] and Klein et al [1978].
4 “But once it becomes economical to have market transaction, it also pays to divide production in such a way that cost of
organising an extra transaction in each firm is the same.” (Coase [1937], p. 95) Also, “Integration holds no advantage over once-for-
all contracts in a perfectly static environment.” (Williamson [1985], p. 89)

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agreements are capable of achieving results not at all worse than those achieved by one single
large vertically integrated firm, still maintaining intact the benefits, by means of an efficient
incentive structure, which are naturally embodied in market transactions. Quantity-dependent
pricing, ties, requirement contracts and exclusive dealings, to make some examples, are often
quoted as cases of these vertical contractual relations. Some of these practices involve initiative
and autonomy all along the vertical chain, posing problems which range from vertical
negotiation, to vertical strategic interaction and to vertical control.
The broad label of “vertical contractual relation” embraces industrial districts, clusters of
small- and medium-sized firms, exclusive networks and all those productive structures which
involve vertical disintegration of activities. Nonetheless, these inter-firm contractual solutions
are deeply different in many respects: the relative role and weight of single firms, the nature of
firms’ cooperation and, above all these, the degree of hierarchy in firms’ vertical agreements.5
In this paper, we compare three vertical integration patterns:

• market transactions,
• vertical integration and
• vertical contractual relations

when the vertical relationship involves innovation. Innovation differs from other intermediary
goods exchanged in vertical relationships because of the key role played by uncertainty.
Regardless the amount of resources invested in R&D activity, the effort and the time devoted to
it, the outcome of any innovative activity is uncertain. Moreover, innovation can be exchanged
only through a fixed pricing mechanism, given the non-separability of the innovative outcome. In
other words, once the innovation has occurred, the innovator and the adopter have to agree on
the price at which the whole innovation is transferred.
The aim of the paper is to investigate firms’ strategic decisions on vertical control in the
special case where vertical contracts regard innovation. According to the structure of the final
market given by the distribution of profits, firms may decide strategically on the degree of
vertical control over the innovation process. We argue that the vertical integration of innovative
and productive activities in one single firm does not necessary brings about an efficient outcome.
Rather, the specialisation of two firms, for instance, in each of the two activities and the
exchange of innovation for a transfer fee through vertical contractual relations can generate no
worse results.
To tackle the problem of vertical control, we model explicitly a multi-stage market game
between two upstream and downstream firms. Payoffs are function of the competitive features of
the downstream market. One payoff parametrization replicates (in our view) Grossman and Hart
framework: market does not allocate “efficiently” property rights, since it does provide “too
many” incentives to the upstream firms to diffuse the innovation as it would not happen in the
presence of vertical integration. However, our analysis discloses other possible worlds, where
the inefficiency is due instead to the presence of strategic uncertainty, as the strategic

5 For a taxonomy, see Becker and Peters [1995].

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environment takes the form of a game with multiple equilibria. This uncertainty is suffered,
depending on the payoff configuration, by either the upstream or the downstream side.
Vertical control can be a solution to this problem. In the paper, we model vertical control by
means of a (game-form) mechanism in which upstream and downstream firms bargain over their
strategic decisions, in order to capture market opportunities. As it will be shown, the outcome of
such bargaining process replicates, depending on the characteristics of the consumer market
demand, some of the most popular ways in which vertical contractual relations are carried out in
the real world.
Traditionally 6, the issue of vertical integration has been has been modeled as a two-player
game. The only noticeable exception is the paper of Bolton and Whinston [1993], which has
some similarities with the approached pursued here.7In that paper, an upstream firm provides an
intermediate good to two potential downstream clients. However, as the upstream firm suffers a
capacity constraint, it is not capable to supply the intermediary good to both its potential
clients; the multiplicity of equilibria arises from the fact that both downstream firms would
prefer to acquire the good, although the upstream firm is indifferent of the identity of its client.8
The remainder of the paper is arranged as follows. In section 2 we set up the model, deriving
the equilibria of the two extreme cases, that is market and hierarchy. In section 3 we design the
mechanism which establishes the vertical relation. Section 4, devoted to additional remarks,
concludes.

2. TWO OPPOSITE BENCHMARKS

The aim of this section is to model, in a very simple fashion, the two extreme cases of vertical
relations, that is market and hierarchy.
Consider the case of a consumer good industry (“downstream”) with two identical firms ( D 1
and D2 ). They buy technology from an “upstream” industry, which is also compound of two
identical firms ( U1 and U 2 ). Following Katsoulakos and Ulph [1996] we model R&D as a
stochastic process: the technology takes the form of a patent, which probability of discovery can
be interpreted as a control variable for the upstream firms (i.e. they fix a given probability of
discovery along a cost curve, which is assumed to be the same for both). Who discovers sets
(independently) a price for the patent, a lump sum to be interpreted as a technology transfer
fee. Given these assumptions, the downstream firms have to decide whether to buy the
innovation and, in the case of joint innovation, from whom. These assumptions characterise in
our simple framework a market vertical relation.
Consider, instead, an alternative scenario (which we identify with hierarchy). Two (identical)
vertically integrated firms ( UD1 and UD 2 ) operate in the same consumer good industry. Both
have a R&D department, in possess of the same technology. If both discover, competition on the
consumer good market will take place with no comparative advantage; the same happens when
no discovery is made. If only one discovers, it faces the trade-off between keeping the

6 See for example, Williamson [1985] or Grossman and Hart [1986].


7 The role of strategic uncertainty in vertical relations is also studied, in somehow a different context, by Bolton and Farrell [1990]
8 Although we do not assume capacity constraints, Bolton and Whinston’s [1993] model replicates, in our view, what is labelled
in the paper as CASE 4 (see § 3 below).

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innovation for itself (enjoying a monopoly position in the consumer good market) or licensing
the patent to the competitor. We assume that this choice is driven only by profit-maximizing
considerations, which depend upon the characteristics of the consumer good demand schedule.
In this section we shall characterize the equilibria of these two extreme settings.
Comparisons are drawn both for the upstream side, concerning the equilibrium amount of R&D
undertaken by upstream firms, and for the downstream side, concerning adoption patterns and
adoption costs for the downstream industry.

2.1 THE NON-INTEGRATED SOLUTION

The non-integrated framework is structured as follows:

STAGE I. The Innovation Game. Here U i ( i = 1,2 ) has to make a (simultaneous) choice over
the set pi ∈[0,1] , setting the probability of discovery along a cost function :[0,1]→ R + , the
same for both firms, giving how much U i has to spend on R&D to achieve a probability of
discovery equal to p i . We assume that the cost function satisfies the standard Inada
conditions, i.e. i) (0 ) = ′(0)= 0 ii) ′( p i ) > 0 iii) ′ ′(p i ) > 0 and iv) lim ′( pi ) = ∞ . After
p →1
i

this choice is made, two (independent) lotteries are drawn, deciding which firm (if any)
discovers. We assume that the outcome of both lotteries is public and common knowledge.

STAGE II: The Adoption Game. In this subsequent stage, each successful U i has to set
(independently) a price for the patent, c i ≥ 0 9; then Di has to decide (simultaneously) whether
(given this is an available option) to adopt, and from whom to buy it.

Each potential adopter will compare c i with the shadow value of innovation, as calculated in
the consumer market game. We assume that the effects of adoption a) can be calculated exactly,
and b) are common knowledge. We also assume that c) it is irrelevant the identity of either the
innovator (i.e. innovations are perfect substitute) or the adopter (i.e. the resulting consumer
market game has the property of symmetry). This set of assumptions allows us to model the
decision regarding adoption by means of a simultaneous-move game following the price setting
stage. Let:

• S i ≡ {A 1 ,A 2 , A } be the set of actions available to Di , where A i denotes the choice of


adoption from U i and A indicates non-adoption;
• W be the profit of Di if it alone adopts the innovation;
• L be the profit of Di if its competitor alone adopts the innovation;
• T be the profit of Di if both adopt the innovation;
• 0 be the profit of Di if neither adopts the innovation.

9 Implicit in this assumption is the impossibility of price-discrimination.

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All profits are intended gross of the technology transfer fee. We shall assume
W
> T > 0 > L .10 Following Beath et al.[1994] we call profit incentive (PI) the difference
( W
− 0 ) and competitive threat (CT) the difference ( T − L ) . With the former (i.e. the
difference between the gross profits for the downstream firm, given that the opponent has not
adopted), we refer to the incentive that would face a firm if it would adopt the innovation in
isolation11 . With the latter, (that is, the difference between the gross profits, given the opponent
has adopted the innovation), we refer to the incentive each firm has to adopt induced by the
fear of losing out market share in advantage of the rival. Without loss of generality, we make the
following assumption:

• ASSUMPTION 1.

W
=1
0< T
<1
(2.1)
0
=0
−1 ≤ L
<0

that is, we normalize the measure scale of the relevant payoffs setting PI = 1 . The payoff ranking
(2.1) contains all the relevant information of the equilibrium in the consumer good market game
(STAGE III), the analysis of which is here omitted. For the sake of simplicity, only pure strategy
profiles will be considered.
We solve the game by backward induction, isolating the set of subgame-perfect equilibria in
pure strategies of this multi-stage game. We start from STAGE II. Given that c i is set (and
publicly announced) prior to the decision whether to adopt, U i is in the position to set c i to
maximize upstream profits: Π U = n i ci − (pi ) , where n i is the number of patents sold by U i .
i

In doing so, U i will act as Stackelberg leader in the adoption game. Three cases have to be
distinguished:

• no innovation is available (this happens with probability (1− p1 )(1− p2 ) ). In this case, no one
will adopt (i.e. D = 0 and U = − (pi ) );
i i

• two successful innovators (this happens with probability p1 p 2 ). Given that innovations are
perfect substitute, no Nash equilibrium of STAGE II can sustain c i > 0 . In other words:
Bertrand competition drives the technology fee to zero. If innovation is free, adoption is
optimal under any payoff configuration, i.e. D = T and U = − (pi ) 12 ;
i i

• one successful innovator ( U1 ) (this happens with probability p1 (1− p2 ) ). This is certainly the
most interesting case; its analysis is contained in the following

10 Implicit in this design is the assumption that D can buy only one innovation, while U might sell two, at no additional
i i
costs.
11 Also referred by Katz and Shapiro [1987] as stand alone incentive.
12 Given that c = 0 , it does not really matter who sells the innovation to whom.
i

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• PROPOSITION 1. The set of subgame-perfect equilibria of STAGE II, in the single-innovator
case, exhibits the following structure:

R1

R2 SPE Π D1 ΠD2 Π U1

R3
R1 (1,A 1 ,A 1 ) T
−1 T
−1 2
R2 (CT ,A 1 ,A 1 ) L L
2CT
R 3 (1,A 1 ,A ) or (1,A ,A 1 ) 0 or
L L
1 L or 0 1

FIGURE 1
The subgame-perfect equilibria of STAGE II in the case of a single innovator

PROOF. We first notice that, under any possible payoff configuration, any choice of
c1 > c1 ≡ max(CT,1) cannot sustain a subgame perfect equilibrium. In fact, the consequence
would be joint non-adoption, given that, in this case c1 is high enough to make A a (strictly)
dominant strategy. On the other hand, any choice of c1 < c1 ≡ min(CT ,1) cannot also sustain a
subgame perfect equilibrium given that, in this latter case, adopting is always optimal, and U1
has a clear incentive to raise the technology fee. Given the feasible range just defined, STAGE II
(we called it the adoption game) is a 2-stage game with observable actions, the extensive form
of which is described in Figure 2.

U1

c1 = c1 c1 = c1

A1 A A1 A
A 1 2c1 , T − c1 , T − c1 c1 ,1 − c1 , L
A 1 2c1 , T − c1 , T − c1 c1 ,1 − c1 , L

A c1 , L ,1 − c1 0,0,0 A c1 , L ,1 − c1 0,0,0

FIGURE 2
STAGE II in the single innovator case

The equilibrium value of c1 will depend on the payoff configuration, that is, the actual values
of T and L . Three cases have to be distinguished:

• CT > PI = 1 (i.e. the region labelled by R 1 in Figure 1). In this case, there is a set of
subgame-perfect equilibria in pure strategies characterised by the action profiles (c1 , A 1 , A 1 )

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with 1 ≤ c1 ≤ CT . To see this, we first look at the game from D1 ‘s viewpoint : given 1 ≤ c1 ≤ CT ,
(non) adopting is optimal only if D2 is behaving in the same way. In other words, the choice of
adoption, when CT > PI = 1, takes the form of a coordination game between the two
downstream firms. In any subgame perfect equilibrium of the game, therefore, D1 and D2 will
select the same action at each information set (i.e. each value of c1 ) and, consequently, U1 will
choose the higher c1 conditional to which both D1 and D2 choose adoption. There is a clear
multiplicity problem here, that we solve in the following way. Any 1 ≤ c1 ≤ CT will expose U1 to
the strategic uncertainty caused by the presence of multiple equilibria, leaving open the
possibility that D1 and D2 coordinate toward joint non-adoption, the outcome that U1 prefers
least. and D1 and D2 prefer most We will therefore assume that U1 will lower c1 just below 1,
in order to ensure joint-adoption. In our interpretation, this equilibrium better characterizes the
transaction costs associated with the strategic uncertainty arising from the presence of multiple
equilibria. 13 According to this interpretation, when CT>PI the resulting subgame perfect
equilibrium outcome will be (1,A 1 ,A 1 ) ., with payoffs distributed as follows:

Di = T
−1
U1 = 2 − (p1 )
U2 = − (p2 )

1
• < CT < 1 (R 2 ) . In this case, there is a unique subgame perfect equilibrium, associated
2
with the outcome (CT ,A 1 ,A 1 ) . Joint adoption, guaranteed by c1 = CT , maximises U1 ‘s
profits, as 2CT > 1 . Equilibrium payoffs as follows:

Di = L

U1 = 2CT − (p1 )
U2 = − (p2 )

1
• CT < (R 3 ) . In this case, the price which can be charged selling the patent to a single Di ,
2
given non-adoption of the opponent, is equal to PI = 1 , value which exceeds the profit of
selling two patents at the lower price of CT. Therefore, backward induction here implies
c1 = 1 , with the resulting unique subgame-perfect equilibrium outcome being (1,A , A ) or
(1, A , A ) , depending on the identity of the adopter. We assume that each equilibrium might
occur with equal probability, with the adopter chosen at random by the innovator.
Equilibrium payoffs as follows:
[ ]=
L
1
Di = 0 or L
with probability ⇒E Di
2 2
U1 = 1 − (p1 )
U2 = − (p2 )

13 The qualitative features of the analysis are not altered if one considers any subgame perfect equilibrium in which c1 <CT.

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We are now in the position to solve STAGE I. Given our assumptions on the cost function, the
optimal investment level p1* = p*2 = p* can be computed as follows:

• R 1 : p* solves k ′(p* ) = 2(1− p* )


• R 2 : p* solves k ′(p* ) = 2CT(1− p * )
• R 3 : p* solves k ′(p* ) = 1 − p*

The three cases depict decreasing profit levels (and therefore R&D equilibrium effort carried
out by the upstream firms), the exact characterization of which clearly depends on the functional
form of .

2.2. THE I NTEGRATED SOLUTION

In this alternative scenario, two vertically integrated firms, UD1 and UD 2 , invest in R&D,
using the same technology as before. Subsequently, they compete in the consumer market
game, which distributes the same payoffs as in the non-integrated case. Strategies and payoffs of
STAGE I and STAGE III are then identical to the previous setting; whilst, the structure of STAGE
II differs and takes the following form:

• STAGE II. The Licensing Game. Here, each successful UD i has to set (independently) a
price for the patent, c i ≥ 0 , then its competitor UD j , with i ≠ j , has to decide whether to
buy the patent.

We shall solve the resulting stage-game by backward induction, as we did in the non-
integrated setting, starting from STAGE II. Three cases have to be distinguished:

• no innovation is available: UD = − (pi ) ;


i

• two successful innovators : UD = T − (pi ) ;


i

• one successful innovator ( UD1 ). Once again, this is the most interesting case and its analysis
is laid down in the following proposition:

• PROPOSITION 2. The integrated solution, in the case of a single innovator, exhibits the
tructure displayed in Figure 3.

PROOF. Here the vertical coalition in possess of the innovation has to decide whether to license
the innovation to the opponent (at the maximum price UD 2 is willing to buy, i.e. CT ), or to
enjoy a monopoly position in the consumer market game. In the latter case, its profit (net of
innovation costs) would be 1, while in the former it would be UD = T + CT = 2 T − L . We
1

call monopoly rent (MR) the difference between these two profit flows.

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In other words, the innovation is sold to the opponent coalition if the following condition is
satisfied:

L
1
MR < 0 ⇔ 2 T
− L
> 1⇔ T
> + (2.2)
2 2

This holds in the region labelled by R 4 where the innovation is sold to the opponent coalition,
with the following implications:

UD1 =2 T
− L
− (p1 )

UD 2 = L
− (p2 )

In the region labelled by R 5 condition (2.2) is not satisfied (and the innovation is not sold), with
the following implications:

UD1 = 1 − (p1 )

UD 2 = L
− (p2 )

1
R4

c Π UD 1 ΠUD 2
R5
R4 (A 1 ,A 1 ) CT 2 T
− L L

1 L R5 (A 1 ,A ) ? 1 L

FIGURE 3
The subgame perfect equilibria in the case of two vertically integrated firms

We now can solve STAGE I. The relevant profit functions for UD1 , in the two alternative
cases:, are as follows:

• CASE 4: Π UD = −( L p1 ) + 2 T p1 + L p2 − T p1p 2 − (p1 ) ⇒ ′(p* ) = − L + 2 T − T p*


1

• CASE 5: Π U = p1 + L p2 − p1p 2 − L p1 p 2 + T p1 p2 − (p1 ) ⇒ ′(p* ) = 1− p* (1+ CT )


1

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3. VERTICAL CONTRACTUAL RELATIONS WITH BINDING TRANSFERS

In our simplified setting, there is always 14 an advantage to be gained from integration, since
a unified decision making structure will eliminate the strategic uncertainty due to the lack of
vertical control. This result is not surprising, since we tuned our assumptions to enhance the
performance of such integrated structure. In our model, there is no formal language to sustain
the traditional arguments against vertical integration, such as the lack of incentives which arises
when relations are set up on a hierarchical basis (in particular when we refer to R&D). With
these considerations in mind, we might try to explore some conditions under which vertically
disintegrated firms could still eliminate strategic uncertainty, although maintaining a separate
property structure (and the advantages which come with it). To this purpose, we introduce the
notion of an efficient contracting relation between U1 and D1 as one which is able to replicate
the vertical integration outcome, still maintaining the non-cooperative flavour which should
characterise a market relation.
To proceed in the analysis, we first set up a comparison between the two alternative solutions
proposed, in order to see, case by case, why the non-integrated solution produces inefficiency
(and how the integrated solution solves it). This is the purpose of the following table:

R1 R2 R3
= (A 1 ,A 1 ),c1 = 1 = (A 1 , A 1 ), c1 = CT

R4 = (A 1 ,A 1 ),c1 = CT = (A 1 , A 1 ), c1 = CT
R5 = (A 1 , A 1 ), c1 = CT = (A 1 , A ),c1 = 1

= (A 1 ,A ),c1 = ? = (A 1 ,A ),c 1 = ?

FIGURE 4
A comparison Table

Each table entry has two rows, which summarise the equilibrium outcome of the non
integrated model (first row) as opposed to the integrated one (second row). Four are the
relevant cases to be discussed:15

• R 1 ∩ R 4 [CASE 1]: here the “efficient” solution (from the viewpoint of the “winning” coalition
{U1 ,D1 } ) would not require a different outcome in the adoption game (i. e. joint-adoption), but
a different (higher) transfer fee. This is because, in the integrated solution, vertical control
vanishes the strategic uncertainty regarding the adoption of D1 . Once D1 has adopted, D2 is
forced to buy the innovation at all costs (i.e. CT > 1 ). To replicate the outcome of the
integrated solution, the coalition {U1 ,D1 } has then to set up a quantity dependent deal, in
which D1 commits itself to adopt the innovation if it is sold at any price below than (i.e. equal
to) CT. If so, U 1 has a clear incentive, if it innovates alone, to bargain (on a separate table) over
the price to pay in exchange of such commitment. In so doing, U 1 simply subsidise D1 , by an

14 More precisely, we should say almost always, since, as we will see, there is a case in which the non-integrated equilibrium
outcome replicates the integrated one.
15 Notice that there is no overlap between the sets R and R (i.e. R ∩ R = ∅ .) Also the set R ∩ R is empty.
1 5 1 5 3 4

11
amount equal to 1 , in the purchase of the innovation at the market price CT > 1 ).This kind of
contractual scheme is often termed forcing in the vertical relation literature. Under such a
contract, adoption is optimal for D1 when the actual price paid for the innovation is lower than
the price it would have paid in the non-integrated case (i.e. 1 ≥ CT − 1). On the other hand,
U1 would never sign such a contract if the additional benefits were enjoyed by D1 only (i.e.
1 ≤ 2(CT − 1) . These two constraints give the feasible range for a sustainable contract:

1 = (1+ )(CT − 1); ∈[0,1] (3.1)

where denotes the share of the pie enjoyed by D1 .


The deal we just proposed solves the problem of demand assurance faced by the upstream
firm. A quantity dependent deal with only one potential adopter is sufficient to guarantee that
the innovation will be sold to all the potential customers, at the maximum price. This case,
although it has been neglected by the theoretical literature in the field, has a strong evidence in
its favour, especially when innovation is involved. It tends to apply in those cases where to be
successful innovation has to generate a standard. 16
• R 2 ∩ R 4 [CASE 2]: in this case the non-cooperative solution replicates the profit-maximizing
outcome. Moreover, U 1 has in its hands all the bargaining power (given it acts as a Stackelberg
leader). No vertical contract is feasible here;
• R 2 ∩ R 5 [CASE 3]; in the non-integrated solution the U1 sells the patent to both D1 and
D2 . This outcome is inefficient, as it generates a flow of profits which is inferior (from {U1 ,D1 }
coalition’s viewpoint) than what would happen if the innovation were sold to D1 alone (given
MR > 0 ). This is the case which reproduces, in our model, the incentive problem stigmatised in
Grossman and Hart [1986] and in all the “property right” literature. Here a contracting scheme
would take the form of an exclusive deal between the two vertical partners: to be a monopolist
in the consumer good market, D1 is willing to pay a “tip” over the prevailing market price in the
case of a single adopter (which is equal to PI = 1 ). A calculation analogous to the one performed
in CASE 1, leads to the following result:

16 The case of the evolution of business relationships between Microsoft and IBM, as described in McKenna [1985], is instructive in
this sense. By and large, information technology industry is bound to display such characteristics because of two elements: patents
set standard and innovation needs market diffusion. In the Microsoft-IBM case, in the early 80s Microsoft accepted to develop for
IBM an operating system for Personal Computer. Microsoft developed MS-DOS. The contractual agreement implied that IBM
installed this operating system as a primary system in its PC and in exchange Microsoft received royalties for every PC sold. Two
points have to be made. One regards IBM, it did not want to embark itself in a field where it did not have expertise and decided to
minimise its risk by contracting out the job to an external supplier. This presented the advantage of being independent and
separate in case of failure, but at the same time bound within a vertical contractual agreement in case of success. The other one
explains Microsoft strategy. At that time Microsoft was completely unknown within the industry, but had a good idea and, more
important, a contract with the industry leader (which was producing complementary products). Microsoft was asked to develop a
software which could have had the widest possible diffusion if used on all PC sold by IBM. This would have meant having the
chance to set a standard to which other hardware producers had to comply with not because of laws, but demand-induced needs
of compatibility. The contract served both purposes, Microsoft broke into the computer industry and IBM was a forecomer in the PC
market.
Another evidence of a similar phenomenon is provided by Rosenbloom and Cusumano [1987], in relation to the borne of the VCR
industry. It is a typical example of the Japanese strategy of perceiving competition as the Japanese firms together against American
and European champions. When JVC developed VHS, Matsushita adopted the patent and set it as a standard for the consumer
market, followed by Hitachi, Sharp and Mitsubishi. This immediately turned a licensing patent into a standard. It must be said,
though, that the Japanese industrial system is different from the American and European ones. Japanese firms, especially those
belonging to the same industry, tend to be characterised by cross-ownership. Firms are completely independent in their decision-
making, but in terms of ownership it is as if everybody is owing small shares of every firm. This explains the team strategy they
adopt especially when launching new product in foreign markets.

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L
≤ 1 ≤ 1− 2CT (3.2)

Notice that, in this case, 1 is negative, as the flow is toward U 1 , and not vice versa. The
intuition goes as follows. Setting c1 = 1 , and therefore throwing D2 out of the market, pays D1
more than the additional price D1 would have paid if c1 were so high to induce D2 not to
adopt. This is the reason why is now D1 willing to transfer resources toward U1 to close the
deal.
• R 3 ∩ R 5 [CASE 4] slightly different the situation depicted by this latter case. The non-
cooperative outcome coincides with the cooperative one: the profit incentive is comparatively
higher, and only one innovation is sold in equilibrium. On the other hand, there is here a clear
incentive for D1 to be the adopter (and therefore D1 is willing to pay an additional fee to enjoy
the advantages associated with an exclusive deal). As in CASE 1, there are transaction costs
associated with the strategic uncertainty generated by the multiplicity of equilibria. However,
differently from CASE 1, is now D1 which suffers this uncertainty, given that U 1 is absolutely
indifferent about the identity of the adopter. An exclusive deal will take here the role of a tie-
breaker: there is no particular reason, from U 1 ‘s viewpoint, to select either D1 or D2 , unless a
prior contract has been previously arranged and a price has been paid to consolidate such
preference relation. In order to be the monopolist in the consumer good market, D1 is again
willing to pay a “tip” over the prevailing market price.17 Given that D1 is the only potential
customer, we know that c1 = 1 . We can now calculate, in the same way we did before, the range
of an optimal transfer:
L
≤ 1 ≤0 (3.3)
2

To summarise: some of the most popular vertical contractual relations can be derived as non-
cooperative equilibria of a game in which the (unique) successful innovator bargains with one of
the downstream firms in order to exploit at best market opportunities. The outcome of such
non-cooperative bargaining stage is left unsolved here, once it has been defined the size of the
pie to be shared as a function of the final market features. We only consider the case in which
there is a unique innovator ( U 1 ), since, in all the other cases the latter has nothing to bargain
(either because it has nothing to sell, or because, when both U 1 and U 1 discover, D1 already
knows it going to have the innovation for fee.

• STAGE I-bis. The Contracting Game. After investment decisions are made, and the identity
of the successful innovator ( U1 ) is revealed, U 1 and D1 announce (simultaneously) how
much each part is willing to pay to the other in order to exchange the innovation at a price
c1 = max(CT ,1) .

17 Market opportunities are too narrow for two adopters and therefore, in equilibrium, only one patent will be sold. In Bolton and
Whinston [1993], the same effect occurs as the innovator is capacity constrained, and therefore cannot satisfy the entire demand.
Whatever is the reason, in both models the lion’s share goes to the adopter (and this is essentially the reason why the adoption
game has multiple equilibria).

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STAGE I and STAGE II are absolutely analogous to the non-integrated case. Let 1U 1D the
transfer announced by U 1 and D1 respectively, with 1 = 1U − 1D measuring the net flow
towards D1 . We define as ∆ˆ 1 the set of transfers which satisfy, respectively, the feasibility
constraints defined by (3.1-3). We already noticed that, when 1 ∈ ∆ˆ 1 , both parties have an
incentive to undertake their reciprocal obligations. This consideration leads to the following
proposition, the proof of which is here omitted:

• PROPOSITION 3. Any strategy profile (( 1


D
,c1 ), ( ,A 1 ) )
for players (U1 ,D1 ) , in the
1
U

contingency of U 1 being the unique innovator, with c1 = max(CT ,1) and 1 ∈ ∆ˆ 1 sustains a
subgame perfect equilibrium of the 3-stage game.

4. CONCLUSIONS

The main benefits of vertical integration, according to the simple model provided here, take
the form of governance rather than production cost savings, reducing the strategic uncertainty
which characterises every market environment. If this is the case, the contract scheme provided
show how vertical control could be achieved even in absence of vertical integration.
Consistently with Grossman and Hart [1986], we have assumed throughout the paper that
vertical integration in itself does not make any new variable observable to both parties, i.e. has
no comparative advantage per se. The advantage takes here the form of vertical control, even if,
as we tried to argue, this is not a special feature of a vertical integrated structure, as the growing
literature on vertical contractual relations gives full evidence (to which our model could provide
an alternative theoretical explanation).
We conclude with some further remarks. First, the set of feasible contracts is greatly
restricted in our model. In particular, the case of an horizontal coalition is ruled out by
assumption, even if there are clear benefits from the players’ viewpoint, to form a cartel in order
to lessen horizontal competition. The emphasis of the paper is placed instead on the possible
vertical links, and the private incentives the firms might experience whenever these links were
established. The preference viewpoint here presented can be summarised as follows: what are
costs and benefits, from D1 ’s viewpoint, to set up an R&D department instead of letting the
market work ? Moreover, only market effects (and not, for example, lock-in effects) are the ones
considered here. The interaction between these two (sometimes competing) forces will be the
object of further research.
Moreover, to make sense of the model provided in § 3, all the relevant payoffs must be
common knowledge. The theoretical setting we deal with is therefore one in which players are
well informed, in the terminology of Varian [1994]. It may be worth to point out that this
feature makes the model quite different with respect to the relevant literature in the field,
where the problem of vertical integration is usually modeled making appeal to some asymmetric
or incomplete information among the players. In this respect we show that the problem of
vertical control exists even when incomplete information is absent, and every rule of the game is
common knowledge among the players.

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