Economies of depth: Technology, market structure and vertical integration

Abstract

In this paper, a formal model of technology-based vertical market structure is interacted with different environments of downstream and upstream strategic behavior. The research is innovative on four grounds: on the one hand, it explicitly establishes mathematical conditions for the assessment of vertical arrangements at the firm level, rigorously defining – as a peculiar production (in)externality - economies of depth. Secondly, it provides equilibrium and welfare comparisons of vertically integrated and non-integrated or decentralized market structures under different assumptions on the intervening productive agents competitive behaviour – final output producers, intermediate product suppliers, and primary factor owners. The exercises highlight transmission mechanisms of market power through intermediate product industries. The consequence of each particular market failure is studied independently (or in absence) of the others, considering ceteris paribus deviations of conduct relative to the competitive paradigm of each side of a transaction. Thirdly, the analysis shares a common well-defined representation of the underlying technologies, relying on duality and other production theory properties with respect to factor prices and usage – allowing for substitutability as for complementarity. Finally, the role of pre-commitment or contractual arrangements – vertical restraint clauses - is discussed in connection to the sequencing or hierarchy of the decision process. A final qualification of the effect uncertainty in upstream markets on equilibrium outcomes is suggested.

Keywords. Economies of depth; Internalities; Vertical integration; Vertical mergers; Intermediation; Intra-industry trade. Economic (mechanism) design: Short and long-run reaction functions; Pre-commitment; Vertical restraints; Trade unions. Monopsony in primary factor markets.

JEL. L14; L22; L42; D23; D62; D40; J50; J42.