Vertical Integration and Communication
Volume: Volume 6, No. 1
Issue: Spring 1975
Pages: pp. 173-183
Authors: Kenneth J. Arrow
Title: Vertical Integration and Communication
Abstract: Among the many possible motives for vertical integration, the one emphasized here is uncertainty in the supply of the upstream good and the consequent need for information by downstream firms. The basic conclusion is that, even when the initial conditions are of the type usually thought of as competitive, the upshot will be a tendency to imperfect competition.
A simple model is analyzed. The supply of each upstream firm is a random variable, which cannot be altered by any decisions. Each such firm knows its supply (or has some information about it) one period in advance. Downstream firms operate under constant returns and risk neutrality with two inputs, the upstream product and capital; the latter must choose one period in advance of output. There is a spot market for the upstream product.
Then, if there is no vertical integration to begin with, a downstream firm will have an incentive to buy one or more upstream firms because this improves his forecast of the spot price of upstream product and therefore his ability to choose the level of capital. There is no incentive, however, to acquire the upstream firm for any other reason. Similarly, given any ownership pattern of upstream firms by downstream firms, there will always be an incentive for each downstream firm to acquire more upstream firms, to improve its forecasting. Hence, no competitive equilibrium with many firms can survive.
JEL Classification
Microeconomic Theory General (0220)
Market Structure: Industrial Organization and Corporate Strategy (6110)
Economics of Uncertainty and Information Game Theory and Bargaining Theory: General (0260)