Economics Letters 192 (2020) 109180

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Economics Letters
journal homepage: www.elsevier.com/locate/ecolet

Vertical integration without intrafirm trade

∗,1
Chrysovalantou Milliou
Department of International and European Economic Studies, Athens University of Economics and Business, Patission 76, Athens 10434, Greece
CESifo, Munich, Germany

article info a b s t r a c t

Article history: This paper shows that a vertically integrated firm has incentives to outsource input production to
Received 19 February 2020 an equally efficient nonintegrated upstream firm that serves its downstream rival. By outsourcing, it
Received in revised form 24 April 2020 raises both its own and its rivals’ cost and generates softer price competition in the final product
Accepted 26 April 2020
market. Both the positive implications of vertical integration on the integrated firm’s profits and
Available online 1 May 2020
its negative implications on consumers and welfare are stronger with outsourcing than with the
JEL classification: commonly presumed insourcing.
D43 © 2020 Elsevier B.V. All rights reserved.
L13
L22
L24
L42

Keywords:
Vertical integration
Two-part tariffs
Raising rivals’ cost
Outsourcing

1. Introduction We revisit the incentives and implications of vertical integra-

A common hypothesis regarding vertical integration is the
significance of intrafirm trade: Intermediate products, such as
raw materials or parts, move between the divisions of a vertically
integrated firm. This property prevails in the theoretical literature
on vertical integration. However, it is not always supported by
data. Recent empirical studies document vertically integrated
firms that outsource input production. Atalay et al. (2014) finds
that the vertical links of U.S. multiplant firms are not associated
with significant intrafirm shipments. Similarly, Ramondo et al.
(2016) and Chun et al. (2017) find limited or zero shipments
between foreign affiliates and their vertically related parent firms
in the U.S. and Japan respectively. Hortaçsu and Syverson (2007)
report that vertically integrated firms in the U.S. cement industry
rely heavily on independent cement producers.
∗ Correspondence to: Department of International and European Eco-
nomic Studies, Athens University of Economics and Business, Patission
76, Athens 10434, Greece.
E-mail address: cmilliou@aueb.gr.
1 I am grateful to Michael H. Riordan for his valuable suggestions. I would
like to thank Stephane Caprice, Emmanuel Petrakis, Ioannis Pinopoulos, Patrick
Rey, Joel Sandonis, the editor, and an anonymous referee for their helpful input.
I would also like to thank the Department of Economics of Columbia University
for its hospitality while part of this paper was written. Full responsibility for all
shortcomings is mine.
tion without the presumption of intrafirm trade. To do so, we
develop a model that gives a downstream firm, which integrates
backwards, the option to source an input from a nonintegrated
upstream firm rather than to source it internally from its up-
stream partner. Prior to integration there are two symmetric
firms in both the upstream and downstream segments of the
market, non-linear contracts are used, and downstream competi-
tion is in prices. We show that, in equilibrium, the integrated firm
opts for outsourcing and raises rivals’ cost more than it would
if it insourced, while it also raises its own cost. As a result, the
absence of intrafirm trade generates a less competitive outcome
in the final product market, and renders vertical integration more
profitable for firms and more harmful for consumers and welfare.
That vertical integration can raise rivals’ cost is extensively
demonstrated in the literature (e.g., Salinger, 1988; Hart and
Tirole, 1990; Ordover et al., 1990; Riordan, 1998).2 Several papers
(e.g., Chen, 2001; Chen and Riordan, 2007) explore the validity
of the raising rivals’ cost effect when the integrated firm can
remain in the upstream market as an input seller, but not as
an input buyer. Our paper fills in this gap. It provides a poten-
tial justification for the empirically observed lack of intrafirm
trade and points out that the anticompetitive implications of
2 See Rey and Tirole (2007) and Riordan (2008) for reviews of the literature
on vertical integration.

https://doi.org/10.1016/j.econlet.2020.109180
0165-1765/© 2020 Elsevier B.V. All rights reserved.
2 C. Milliou / Economics Letters 192 (2020) 109180

vertical integration in successive oligopolistic markets could be McAfee and Schwartz, 1994). We obtain a unique equilibrium
underestimated. by imposing the ‘contract equilibrium’ concept (e.g., Crémer and
The analysis of a firm’s decision to source an input, which is Riordan, 1987; Rey and Vergé, 2019) according to which no
capable of producing in-house, from an external source lies at the contracting pair has an incentive to alter its contract terms, taking
heart of the literature on outsourcing (e.g., Shy and Stenbacka, as given the equilibrium contract terms of the other contracting
2003; Sappington, 2005; Arya et al., 2008). Our paper extends pairs.8
this literature that typically focuses on outsourcing through lin-
ear contracts and/or to more efficient upstream firms and does 3. Analysis and results
not study the implications of vertical integration.3 It shows that
the widespread practice of outsourcing by competing firms to a
Both with and without vertical integration, in the last stage,
common input supplier can arise even if the supplier is equally
each firm i, with i, j = U1 D1 , D1 , D2 and i ̸ = j, chooses pi to
efficient when non-linear instead of linear contracts are used.4
maximize its (gross from fim ) profits: πi (pi , pj ) = qi (pi , pj )pi −
ki qi (pi , pj ), where ki is its per unit cost, with k1 ∈ {s, w12 } and
2. Model
k2 = w22 under integration, and ki = wim otherwise. The
resulting prices are:
There is a vertically related market with two upstream firms,
U1 and U2 , and two downstream firms, D1 and D2 . Downstream a(2 − γ − γ 2 ) + 2ki + γ kj
firms manufacture differentiated final products using, in an one- pi (ki , kj ) = . (1)
4 − γ2
to-one proportion, an input that they obtain from either U1 or
U2 . Demand faced by Di , with i = 1, 2, is given by the standard Vertical Separation
(a−pi )−γ (a−pj ) Absent vertical integration, competition between U1 and U2
linear demand function: qi (pi , pj ) = , where pi is the
1−γ 2 results in marginal cost input pricing, wim S S
= s, and fim = 0.
price of its product, pj is the price of its rival’s product, and γ , S
Equilibrium prices, pi , are, thus, given by (1) with ki = kj = s,
with γ ∈ (0, 1), is the degree of product substitutability. Each
and net equilibrium profits are:
Um , with m = 1, 2, produces the input at constant marginal cost,
s, with a > s ≥ 0, and sells it to Di through a two-part tariff (1 − γ )(a − s)2
contract that includes a wholesale price per unit of input, wim , πDSi = ; πUSm = 0. (2)
(2 − γ )2 (1 + γ )
and a fixed fee, fim .
U1 and D1 decide whether or not to integrate. Their decision Vertical Integration
is made in the first stage of the game. If they integrate, the We start by considering, as a benchmark, the case in which
downstream subsidiary of the newly formed integrated firm, under vertical integration there is intrafirm trade by assumption.
U1 D1 , either insources the input, i.e., obtains it from its upstream Prices in the last stage are given again by (1) with k1 = s and
partner at marginal cost s, or outsources it, i.e., buys it from U2 k2 = w22 . In the previous stage, U2 makes an offer to D2 ; it solves:
at (w12 , f12 ). U1 D1 ’s input sourcing decision occurs in the second
stage, after U2 simultaneously and separately offers (w12 , f12 ) and max πU2 (w22 , f22 ) = (w22 − s)q2 (p2 (w22 , s), p1 (s, w22 )) + f22 , (3)
(w22 , f22 ) to U1 D1 and D2 respectively.5 , 6 If, instead, firms remain w22 ,f22
separated, both U1 and U2 make simultaneously offers to D1 and
D2 . Lastly, firms observe all the contract terms and set the prices s.t. πD (p2 (w22 , s), p1 (s, w22 )) − f22 ≥ 0
2
of the final products.7 The constraint is binding. Rewriting and solving (3), yields:
Multiple equilibria can arise when an upstream firm makes si-
aγ 2 (2 − γ − γ 2 ) + s 8 − γ 2 (6 − γ − γ 2 )
[ ]
multaneous and separate offers to competing downstream firms, w I
= . (4)
due to the multiplicity of beliefs that they can form when they
22
4(2 − γ 2 )
receive out-of-equilibrium offers (e.g., Hart and Tirole, 1990;
We observe that, in line with the literature (e.g., Salinger, 1988;
Ordover et al., 1990; Chen and Riordan, 2007), vertical integration
3 For exceptions that study outsourcing to equally efficient upstream firms with intrafirm trade raises rivals’ cost, w22 I
> s. The resulting
in markets with quantity competition, see e.g., Colombo and Scrimitore (2018) equilibrium prices, pI1 and pI2 , satisfy: pI2 > pI1 > pS1 . The first
and Milliou (2019).
4 In many industries, competitors source inputs from the same supplier. For
inequality is a straightforward implication of the rival’s higher
instance, in the electronics industry, both Apple and Samsung source ceramic
marginal cost and along with strategic complementarity leads to
capacitors from Murata. Similarly, in the car industry, Ford Motors and General the second inequality — the higher prices under integration. Net
Motors purchase automotive components from Flex n Gate. equilibrium profits are:
5 U D can commit to outsourcing by including a penalty in its contract with
(a − s)2 (1 − γ )[4 + (2 − γ )γ ]2
1 1
U2 . If production adjustments are needed to make inputs compatible with final
πUI 1 D1 = ; (5)
goods, U1 D1 can also commit by tailoring its final good production to U2 ’s input. 16(1 + γ )(2 − γ 2 )2
This assumption is common in the outsourcing literature.
6 We assume, as in Salinger (1988), Ordover et al. (1990) and Sappington (a − s)2 (1 − γ )(2 + γ )2
πUI 2 = ; πDI 2 = 0. (6)
(2005), that U1 D1 does not make an offer to D2 . In our setting, U1 D1 , unless 8(1 + γ )(2 − γ 2 )
it has lower input production cost (Chen, 2001), prefers not to make an offer.
Otherwise, the wholesale prices equal s and vertical integration neither raises Clearly, incentives for vertical integration are present, πUI D >
1 1
rivals’ cost nor softens competition. Hart and Tirole (1990), among others, πUS1 + πDS1 . But vertical integration increases prices and is detri-
question the integrated firm’s commitment ability. We can show, in line with
Avenel and Barlet (2000), Choi and Yi (2000) and Church and Gandal (2000),
mental for consumers and welfare.
that U1 D1 can commit by shutting down or modifying its line for producing We turn now to the case in which insourcing is not presumed.
D2 ’s tailored input. In stage two, U2 makes its offer to each firm i, with i, j = U1 D1 , D2
7 The assumption that firms know all the contract terms when they set their
prices can be found in many papers in the literature on vertical integration in
successive oligopolies (e.g., Ordover et al., 1990; Chen, 2001). If firms did not 8 The alternative possibility is the use of passive beliefs or wary beliefs
know the rival’s contract terms, vertical integration with or without intrafirm equilibrium. However, as Rey and Vergé (2004) demonstrate when downstream
trade would not affect outcomes and vertical integration incentives would be competition is in prices, as in our setting, a passive beliefs equilibrium may not
absent just like when competition is in quantities. exist and wary beliefs equilibria are rather intractable.
 C. Milliou / Economics Letters 192 (2020) 109180 3

and i ̸ = j, taking as given its equilibrium contract terms with firm intrafirm trade and increases its own marginal cost, it also fore-
j, (wj2
N
, fj2N ): goes its cost advantage relative to its downstream rival (k22 =
w22
I
> k12 = s). If linear contracts were used, and thus, fixed
max πU2 (wi2 , fi2 ) = (wi2 − s)qi (pi (wi2 , wj2
N
), pj (wj2
N
, wi2 )) + fi2 (7) fees were not available, then, as demonstrated in the literature
wi2 ,fi2
on outsourcing (e.g., Arya et al., 2008), the softer competition
+ (wj2
N
− s)qj (pj (wj2
N
, wi2 ), pi (wi2 , wj2
N
)) + fj2N , would not suffice to compensate the integrated firm for its loss of
cost advantage; hence, the integrated firm would not outsource
s.t. πi (pi (wi2 , wj2
N
), pj (wj2
N
, wi2 )) − fi2N ≥ πidN , to an external upstream firm unless the latter was more efficient
where πidN denotes firm i’s disagreement payoff. D2 has no out- in input production. Under non-linear contracts, though, U2 can
side option; hence, πDdN = 0. In contrast, U1 D1 has the option sufficiently compensate the integrated firm through the fixed fee
2
and serve as a common input supplier of both U1 D1 and D2 . In
of insourcing, thus, πUdND = πU1 D1 (p1 (s, w22
N
), p2 (w22
N
, s)).9 Taking
1 1 particular, U2 transfers to U1 D1 part of the higher profits of D2 ,
into account the binding constraints, we solve (7):
due to the softer competition, by setting f12 N
< 0. The closer sub-
γ 2 (a − s) stitutes products are, the more heavily U2 needs to subsidize U1 D1
w12
N
= w22
N
=s+ . (8) through f12N
to induce outsourcing since downstream competition
4
is fiercer and the cost advantage of the integrated firm is more
An important observation is that vertical integration raises rivals’
valuable. In fact, when γ is too high, the piece of the pie that U2
cost more without than with intrafirm trade, w22
N
> w22
I
. We state
needs to offer to U1 D1 is so big, that is better off supplying only
this formally in Proposition 1.
D2 .
Does a downstream firm want to vertically integrate when
Proposition 1. Vertical integration raises rivals’ cost more with
it does not source the input from its upstream partner? The
outsourcing than with insourcing.
answer is yes. In fact, its vertical integration incentives are then
Although with outsourcing, vertical integration causes a larger stronger, πUN D > πUI D . Intuitively, a larger pie is generated
1 1 1 1
raise in rivals’ cost, it does not, in contrast to vertical integration under vertical integration with outsourcing than under either
with insourcing, cause full or partial market foreclosure.10 The vertical integration with insourcing or no vertical integration. The
downstream rival’s market share remains intact post integration. integrated downstream firm uses its outside option of in-house
This is so because vertical integration with outsourcing raises the input sourcing to extract a sufficiently large piece of the pie.11
cost of the integrated firm too, wi2 N
> s, and equalizes the variable The same reason that makes vertical integration more ben-
input costs of the downstream competitors. eficial for producers without intrafirm trade, namely, the softer
Next, we examine whether the vertically integrated firm in- competition in both upstream and downstream markets, makes
sources or outsources. The answer is provided by Proposition 2. it more harmful for consumers and welfare. It follows that the
anticompetitive implications of vertical integration can be more
Proposition 2. In equilibrium, the vertically integrated firm out- severe when the merged firm outsources to the same upstream
sources if γ < 0.969, and insources otherwise. supplier as its downstream rival. Stated differently, vertical inte-
gration can raise more serious anticompetitive concerns when it
Proof. U1 D1 outsources if only if its net profits when it accepts does not cause the foreclosure of nonintegrated upstream firms
the offer of U2 , πUN D = πU1 D1 (pN1 , pN2 ) − f12 N
, are higher than when than when it does.
1 1
it rejects it, πU D = πU1 D1 (p1 , p2 ), where pNi = pi (wi2
dN dN dN N
, wj2
N
),
1 1 4. Conclusion
p1 = p1 (s, w22 ), and p2 = p2 (w22 , s). That is, if and only if
dN N dN N

πUN1 D1 > πUdN1 D1 . Taking this into account, the best that U2 can do We have provided a strategic explanation for vertical integra-
to satisfy this condition is to offer (w12 N
, f12
N
) and (w22N
, f22
N
) to U1 D1 tion without intrafirm trade. The integrated firm may outsource
and D2 respectively, where f12 N
1 , p2 ) −
= πU1 D1 (pN1 , pN2 ) −πU1 D1 (pdN dN
input production to an equally efficient nonintegrated upstream
ε and f22 = π2 (p2 , p1 ), with ε > 0 and ε → 0. Furthermore, we
N N N
firm to further raise the cost of its downstream rival as well as
find that with this offer πUN D > πUI D . Does U2 have incentives to raise its own cost, thereby generating a less competitive final
1 1 1 1
to make such an offer? Its net profits when it does are: πUN = products market.
2
2(wi2 N
− s)qi (pNi , pNj ) + f12
N
+ f22N
. Alternatively, U2 can refrain from Our results point out that it is crucial to treat a firm’s in-
making an offer to U1 D1 . In such a case, its net profits are given put source as endogenous to better account for the potential
by (6). We find that U2 makes the offer, πUN > πUI , if and only if implications of vertical integration. The anticompetitive effects
2 2
γ < 0.969. ■ of vertical integration could be more severe when integration is
not accompanied by intrafirm trade and, therefore, it could take
greater efficiencies to justify it. In light of this, an interesting
Although the nonintegrated upstream firm is equally efficient
extension for future research is the study of vertical integration
in input production, it can convince the integrated firm to buy the
when downstream firms choose both their merging partners and
input from it. Why? Recall that when it outsources, the integrated
their input suppliers when upstream firms differ in efficiency.
firm increases both its own and its rival’s cost (Proposition 1).
A straightforward implication is that both firms charge higher
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