International Journal of Industrial Organization 7 (1989) 369-380.

North-Holland

VERTICAL INTEGRATION BY MEANS OF SHAREHOLDING

INTERLOCKS

David FLATH*
North Carolina State University, Raleigh, NC27695-8110, USA

Final version received October 1988

Vertically related Cournot oligopolies trading at arms’ length produce more output when
upstream firms own equity shares in downstream firms, particularly when the equity shares are
exclusive in the sense that no two upstream lirms own shares in the same downstream firm.
Shareholding by downstream firms in upstream firms has either the opposite effect on output or
no eNect. The reason for the asymmetry is that with arms’ length .transactions, upstream firms
are lirst movers and downstream firms are second movers.

1. Introduction

Recent papers have demonstrated that noncontrolling shareholding links

among competitors induce horizontal integration [see Reynolds and Snapp
(1986), Bresnahan and Salop (1986)]. Such links are often the result of joint
ventures by competing companies and are occasionally also the result of a
company’s decision to hold stock in another company with whom it
competes. Reynolds and Snapp (footnote 4, p. 142) allude to Carl Zeiss’
acquisition of one-fifth of the stock in Bausch and Lomb in 1907, and
Swedish Match Company’s acquisition of a one-third interest in Diamond
Match Company prior to 1944. Direct shareholding links between vertically
related firms are far more common.
If equity interests among rivals induce horizontal integration, perhaps
equity interests in suppliers or customers induce vertical integration. DuPont
once owned 23 percent of the stock in General Motors and was the major
supplier of paint and fabric to GM. This was ruled by the Supreme Court to
have violated antitrust laws on the basis that DuPont’s stock interest
enabled it to gain the business of GM on grounds other than ‘competitive
merit.” Many companies have modest ownership stakes in suppliers or
customers.
*I thank Rob Masson for his many useful comments.
‘Unired States v. E.I. DuPont de Nemours Co., Supreme Court of the United States, 1957.

0167-7187/89/$3.50 0 1989, Elsevier Science Publishers B.V. (North-Holland)

370 D. Flath, Vertical integration by shareholding interlocks

In Japan there are groups of companies linked mainly through partial

equity interests. These six groups, known as keiretsu, include most of the
largest corporations in Japan. The corporations in a single keiretsu are
generally not horizontally related to one another, but rather are related in a
complex input-output arrangement. Caves and Uekusa (1976, p. 61) have
speculated that the historical precursors of the keiretsu, the zaibatsu,
achieved a degree of vertical integration via their share linkages.
What is required for evaluating the partial equity interests in these various
examples is a precise model that relates the production equilibria to the
share interlocks. Reynolds and Snapp (1986) and Bresnahan and .Salop
(1986) have achieved this for the case of joint ventures by competing firms.
The basis for their work is the simple Cournot model. The present paper
extends this analysis to the case of direct share interlocks among firms in
vertically related Cournot oligopolies. An important finding is that down-
stream firms’ equity interests in upstream firms are ineffective at inducing
vertical integration. Upstream firms shareholding in downstream firms does
induce vertical integration, and is rather more effective in doing so if the
shareholding links are exclusive.

2. Assumptions
A number of assumptions are to be maintained throughout the paper.
First, firms produce subject to constant returns to scale, are identical to one
another, and face constant elasticity of demand. Demand elasticity is greater
than one. This assures that the area under the demand curve is a proper
integral, which rules out some nonsense results.

A.1 Market Demand. Let the inverse market demand for some good, y, be
P,=fpy_‘“, where P, is the price, Y the industry output, 4 a shift parameter,
and r> 1 the absolute value of the (constant) elasticity of demand.

A.2 Production Function. Let the production function of y be Leontief with

1- I. That is, let y = A-ix, where x represents units of the sole
coefficient
input.

A.3 Cost Functions. There are n, identical producers of x, each with

constant marginal cost of production c. There are ny identical producers of y,
each of which regards the price of X, P,, as a parameter.

It is assumed that each firm seeks to maximize the value of its profits,
including returns on any shares held in horizontal or vertical counterparts,
but controls only its own output. In the terminology of Bresnahan and Salop
(1986), firms are assumed to have ‘silent financial interests’ in other firms. In
 D. Flarh, Vertical integration by shareholding interlocks 371

adopting this assumption I am limiting attention to cases in which the only

intertirm transmission of profits is through the returns on stockholdings, and
stockholdings do not enable any firm to control the output of other firms. If
these cases only include instances of modest levels of cross-shareholding they
are still of empirical interest.

A.4 Silent Financial Interests. Each firm’s objective is to maximize the

value of its assets, including equity holdings in other firms, but it controls
only its own output.

Finally, firms are held to be in a static noncooperative equilibrium in

which strategies are the selections of quantities. The crucial assumption of
this equilibrium of vertically related Cournot oligopolies, is that both
upstream and downstream firms treat their respective input prices as
exogenous and their respective output prices as endogenous.2 Here, the y
producers treat P, as exogenous and consider P, to be determined by the
industry supply of y through the demand function for y. The x producers
treat c as exogenous and consider P, as well as P, to vary with conjectural
changes in x so as to maintain equilibrium in the downstream industry. All
treat outputs of rivals as exogenous to conjectured variations in their own
outputs.

A.5 Cournot-Nash. Let the producers of x and y be in a static Cournot-

Nash equilibrium in which choices of quantities are strategies and in which
each regards his respective input price as exogenous and his respective
output price as endogenous.

This assumption holds that transactions are at ‘arms’ length’. Buyers and
sellers deal with one another obliquely, perhaps through a passive inter-
mediary or impersonal market, not directly. Terms of trade between any
particular buyer and seller are not therefore the result of their negotiating
and forming a contract. This assumption may be a correct representation of
some vertical transactions but not others.
The alternative to the arms’ length approach is to model trading partners
as cooperating explicitly in setting outputs and dividing profits. If the game
is one in which side payments are allowed, the sets of cooperating firms can
be expected to attain their respective joint profit maximizing outputs, and
once these are well understood the only matter to resolve will be that of the
division of profits among the firms. The present essay, although it only
explicitly treats noncooperative equilibria, could be considered a necessary
rGreenhut and Ohta (1979) and later Perry and Groff (1985, p. 1310), also suggest this same
concept of equilibrium for successive oligopolies. But Waterson (1980) adopts a quite different
approach to the problem of successive oligopolies, one that is a generalization of Cournot’s
model of a zinc monopolist and copper monopolist selling to an atomistic brass industry.
372 D. Flath, Vertical integration by shareholding interlocks

prelude to the treatment of the cooperative equilibrium (of the output game
played by vertically related firms with shareholding interlocks). This is
because in the Nash bargaining theory and its variants, the noncooperative
outcome enters the determination of how the payoffs are divided when there
is cooperation.

3. Vertical shareholding interlocks

I now consider the effects of vertical share linkages under the assumptions
described in the previous section. Here, suppose that there is no horizontal
cross-shareholding. The income emanating from downstream and upstream
firms, respectively, can be represented in matrix notation:

where QY is a matrix of dimension nY by n, with elements representing y

producers’ fractional shareholdings in x producers and LI_ is a matrix of
dimension n, by nY with elements representing x producers’ fractional
shareholdings in y producers. X and 72, as well and 1 and zY are column
vectors of outputs and incomes, and P,-c as well as P,- AP, are scalars
representing profit margins. (I shall adopt the notational convention that
underlined variables are either vectors or matrices and that all other
variables are scalars). Eqs. (1) and (2) may be combined to form a single
matrix equation,

(3)

Equivalently, we have

(l-a-‘g=& (4)

This lists the objective functions of firms in the presence of vertical

shareholding interlocks. The basis for asserting that IQ is the objective
function for i in choosing its output is that if the stock market is efficient, 7~
is the value of firm i’s stock. To see why, notice that an efficient stock market
will value equities such that the value of all the stock held by individuals
rather than by firms equals the summed operating profits of all the firms
 D. Flath, Vertical integration by shareholding interlocks 313

(anyone who held all stock other than that held by firms would be in effect
the sole claimant on the operaing profits of all the firms). if II is the column
vector of market values of all stock in each firm (including that held by
firms), then (L-D& is the vector of values of stock in each firm held only by
individuals. From (4) this equals the vector z of operating profits of each
firm only if u=q3 Thus 7Lirepresents the market value of firm i’s stock as
claimed. This is the rationale for stating that rr is the vector of objective
functions of the firms in choosing their outputs: Each firm seeks to maximize
the market value of its own stock.4
To solve for the equilibrium, one differentiates (4) appropriately to yield
the set of reaction functions, keeping in mind the assumption that both
upstream and downstream firms regard their respective input prices as
exogenous and their respective output prices as endogenous, and finds the
solution to the reaction functions. From such a procedure one finds that in
the special case of no shareholding interlocks, Q=O, the equilibrium price-
cost margin for the entire vertical chain is:

Here the price-cost margin for the entire vertical chain is higher than would
be attained under either forward integration (= l/n,c) or backwards integ-
ration (= l/nJ). This result is in the literature [see Greenhut and Ohta
(1979)], and has come to be referred to ads ‘double marginalization.” It
would have been natural to conjecture that vertical shareholding interlocks
tend to induce such Cournot industries to behave as though vertically
integrated and to produce more output, lowering the final price Cjust as
horizontal shareholding induces Cournot industries to behave as if cartelized
and produce less output, raising the price, as demonstrated by Reynolds and
Snapp (1986) and Bresnahan and Salop (1986)]. In fact, that vertical share
‘A corollary is that if one simply added up the ni across firms the total would exceed the
operating profits in the industries (=(P-Ic)Y). There is a double counting involved in simply
adding the xi. The operating profits of any firm i are included in its own ni and in the x of firms
that hold an equity interest in i.
4To define the tirm’s objective function for modifying its ownership structure, as opposed to
choosing its output, a full capital market specification would be necessary. This is a problem for
a different paper, one that treats the pattern of cross-shareholding as endogenous.
‘Because I have assumed a Leontief production function for the downstream industry and
constant returns to scale for the upstream industry, vertical integration lowers the final price as
well as lowering the price-cost margin for the entire vertical chain. The special implication of
Leontief technology is a dominant theme in the literature regarding the effects of vertical
mergers on prices, profits, and outputs. For references to that literature see Blair and Kaserman
(1983), especially chapters 3 and 4.
314 D. Flath, Vertical integration by shareholding interlocks

interlocks induce expansions of output turns out not to be true in general.

To illustrate the intuition behind this surprising result, I will describe two
very special and highly symmetric cases.

Case 1: Symmetric and nonexclusive vertical shareholding interlocks. Let

each producer of y hold the fraction 6, of the shares of each producer of x,
and let each x producer hold the fraction 6, of the shares of each producer
of y. Necessarily, 0 5 nxsx -C1 and 05 n&j,,< 1. Here each element of lIY is
equal to 6, and each element of IIX is equal to 6,, and

(p@-l=I+ l nxvY!c_CYc!‘__, (6)

1 - n,nYSXi5Y(- -6,u’ j n,@,u >

where the symbols 11’stand for matrices of various with a one in every space.
From (6) and (4), the objective functions of a typical y supplier and typical x
supplier here can be expressed as

Xyl =y,(P,-a-Q 1+ nX6X6y

( 1 - n,ny6xby >

nXdy and (7)

+x’Px-C)(l-n,n,s,sy)’

+ J@y
- ;ipJ( 1 _ &,S,fj,)’ 03)

where x and y represent identical outputs of individual firms and bars

indicate variables regarded as exogenous by the respective firms. Each firm’s
profit depends to some extent on the operating earnings of every other firm,
including horizontal rivals as well as vertical counterparts. The reason for
this is that even though firms do not themselves hold stock in horizontal
rivals, they do hold stock in vertical counterparts and these hold stock in the
rivals. For instance, y, holds stock in x1 who holds stock in y,, etc., ad
infinitum.
After some algebraic manipulations one finds that the following holds in
equilibrium:

pY-p_M,2_+
1
Y ny5 Cl -&d,(l +n,(n,- 1Nl
 D. Flnth, Vertical integration by shareholding interlocks 375

x(5 (l--$L(& (1-;)++(1-;))). (9)

Comparative statics follow from differentiation of (9):

aM -4
-=
- l))l
88, Cl - Q,( 1+ ny(nx

=0 if 6,=0
(10)
i >O if 6,>0

(1 +n,(n,- 1))
aM
9
as,=

<O if 6,=0 or n,=l. (11)

More cross-shareholding just be upstream (x) firms induces a lower final

price, but cross-shareholding by downstream (y) firms does not and indeed
may even induce a higher final price.t6 This asymmetry in effects of cross-
shareholding by upstream and dowmstream firms has an intuitive basis. The
upstream (x) firms are first movers; they anticipate the effects of their choices
of quantity on the behavior of the downstream (y) firms. The dowmstream
(y) firms are second movers; the choices of the upstream (x) firms are
predetermined at the time downstream firms choose - The supply of x is
imbedded in the price of x which is treated by the downstream (y) firms as a
given. To the extent that upstream (x) firms hold shares in the downstream
(y) firms but not vice versa, the upstream firms will play less aggressively and
choose larger quantities and this results indirectly in a lower final price; thus
aM/d8, t0 if 6, =O. Similarly, to the extent that downstream (y) firms hold
shares in the upstream (x) firms, the downstream firms will play less
aggressively which by itself would tend to lower the final price. But in
anticipation of less aggressive play by the downstream firms, the upstream firms
will play more aggressively and this just offsets the lesser agressiveness of
6The signs of (10) are inferred as follows: From (lo), dM/dd,>O iff
(~/~s)(l-(l/n,)~6,(M-(l/n,~)lt-n,(n,-1)), but Mzl and {>l, which implies Mt>l. Also
~1~21 and n,hl, which implies (l+n,(n,-l))>l. Thus (l-(l/n,)<(Mt-(l/n,)(l+n,(n,-1))
and so aM/&S, > 0 if 6, > 0.
376 D. Flath, Vertical integration by shareholding interlocks

downstream firmsif 6,=0, but more than offsets it if 6,>0, so that

aM/ah,=O if 6,=0, and aM/&$,>O if 6,>0.
In cases where upstream firms and downstream firms both hold shares in
one another (6,6,>0), additional shareholding by either type of firm will also
induce horizontal integration at both levels of production. This effect will
dampen and can even offset the effects of added cross shareholding by the
upstream firms described in the above paragraph. This is why aM/aS,can be
greater than zero if 6,> 0 and n,> 1. if n, = 1 there is no possibility of
increased horizontal integration at the upstream level and this apparently is
enough to prevent iYM/ad, from being greater than zero.
Some limiting cases are illuminating and follow immediately from (9).

1.1 If 6,=0, that is, no cross-sharing by upstream (x) firms, then the
price-cost margin is

P,-AC
=L+L
PY n,5 n.2

1.2 If 6, =O, that is, no cross-shareholding by downstream (y) suppliers,

then the price-cost margin is

P,-AC
PY =$+$(I-$$ (I-nfc)

1.2.1 If in addition to 6,=0, nx= ny= n, the price-cost margin becomes

P-k 1
L=ns+(1-6”) 5 I-$
PY ( >

=M,--5 l-+ .
( >

The price-cost margin in 1.1 is identical to that in (5). Cross shareholding by

just downstream (y) firms and not upstream (x) firms has no effect on the
final price. From 1.2 it is clear that cross shareholding only by upstream (x)
firms causes a reduction in price where, as assumed here, demand is elastic.
With 6,=0, as 6, approaches its upper bound of l/n,, the price-cost margin
 D. Flath, Vertical integration by shareholding interlocks 311

does not in general attain the same low level as under complete forward
integration (= l/n.& if the upstream (x) industry is a monopoly however
(n,= l), it does attain this level.

Case 2: Symmetric and exclusive vertical shareholding interlocks. To illus-

trate the effects of exclusive (and reciprocal) shareholding ties under the same
‘arms’ length’ transactions framework adopted throughout this essay, sup-
pose that n, = nY = n and that the matrix of fractional ownership of y firms by
x firms is LL_=sJ, and the matrix of fractional ownership of x firms by y
firms is &=sJ. Here Oss,< 1 and OSs,< 1. Find

(L-Q)-‘=1
1 -S& (_-Li_sY!
1
SJ i I ’ (12)

From (12) and (4), the objective functions of a typical y supplier and a
typical x supplier become

(13)

n,=x,(P,-q
(i’- 1 XY
+Yl(py--px)
(* >. XY

Because the share interlocks are both exclusive and recipocal, each firm’s
profits depend only upon its own operating earnings and that of the one
counterpart with which it is linked.
Under the presumption that firms will not deal exclusively with the
counterparts in which equity interests are maintained, terms such as @,/c?x,
and ~xi/ayi that occur in the reaction functions based on differentiation of
(13) will equal (l/n)l-’ and (l/n)A, respectively.’ One finds that the
following holds in equilibrium:

!++i+
(1 -sJl-$)
Y
( >1-y nt

‘If instead there is exclusive dealing then these terms will equal 1-r and 1. The absence of
exclusive dealing is not crucial to the main results that follow except that one might question
the appropriateness of the arms’ length framework in any case in which exclusive dealing was
present. The question of whether exclusive dealing is subgame perfect and how the presence of
shareholding interlocks affects this is deferred to another essay.
378 D. Flath, Vertical integration by shareholding interlocks

(14)

Again, comparative statics follow from differentiation.

%
g!= M-L 2 =0 if s,=O

( >9
.._u
(15)
4 >O if s,>O.

( 1
l-3 1-s
.as,-- <o. (16)
1-y nt
( >
As in the case of nonexclusive shareholding links (and for the same reason),
cross-shareholding by upstream (x) firms induces a lower final price but
cross-shareholding by downstream (y) firms does not.
The limiting cases follow quite obviously from (14):

2.1 If s,=O then the price-cost margin is

P,-AC

PY
2,’
n5 nt (1-Lnt> =M,.

2.2 If s, = 0, then the price-cost margin is

P,-AC 1
=Q+(l-s,) $ 1-i
p, ( >

=M,-2 l-$ .
( >

One notes the similarity between 2.1 and 1.1. As in the case of nonexclusive
links, exclusive shareholding by downstream (y) firms alone is ineffective at
expanding the final output.
Comparison between 2.2. and 1.2.1 establishes that the price reducing
effects of exclusive vertical shareholding interlocks are more powerful than
 D. Flath, Vertical integration by shareholding interlocks 379

those of nonexclusive share interlocks. In making this comparison, it should

be kept in mind that s, represents shareholding by each upstream (x) firm in
only one downstream (y) counterpart, whereas 6, represents fractional
shareholding by each upstream firm in all downstream firms. The upper
bound of s, is 1; the upper bound of 6, is l/n,. Any given fractional claims of
upstream (x) firms on the assets of downstream (y) firms, induce a lower final
price P, if the claims are exclusive. That is, for s, and 6, such that s,= nd,,
the right-hand side of 2.2 is less than that of 1.2.1.
This finding might explain the ‘one-set’ characteristic of the keiretsu, the
tendency for the major Japanese industrial groups to include a member from
each industry but seldom more than one from the same industry [Miyazaki
(1980)]. If an objective of the keiretsu shareholding interlocks is to induce
vertical integration, then the interlocks will be more effective if they are
exclusive, which they necessarily will be if they link only one firm from each
industry.

5. Conclusion
There are numerous instances of actual firms holding equity shares in
vertical counterparts. A first step in understanding the motivation for such
shareholding interlocks is to develop a precise model that relates the
shareholding to the production equilibrium. This paper has examined the
production equilibria of vertically related Cournot oligopolies under several
different types of shareholding interlocks. If just downstream firms hold
shares in upstream firms, vertical integration is not induced. If upstream
firms hold shares in downstream firms, vertical integration is induced,
particularly if the shareholding ties are exclusive.
Further steps in the analysis of vertical shareholding ties are logical
corollaries of my first step. It remains to test the robustness of my
conclusions with respect to alternative assumptions about technology and
demand. It is also of interest whether vertical shareholding interlocks require
cooperation between firms, even assuming as here that firms do not
cooperate in choosing outputs. That is, if the stock market is efficient will
firms tend unilaterally to acquire shares in vertical counteparts or will they
do so only if assured of some quid pro quo from the target firms? A further
question is whether vertical shareholding ties might play a role in assuring
the stability of cooperation in setting output prices and quantities; the
framework explored here assumed the absence of such cooperation. And
finally it remains to study the empirical relevance of any conclusions. For
instance, in the keiretsu is there a tendency for upstream firms to hold shares
in downstream firms rather than the reverse? Or for that matter, is there a
tendency for shareholding ties to link trading partners rather than firms
which are not trading partners?
380 D. Flath, Vertical integration by shareholding interlocks

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