Quality-Improving Relation-Specific Investments and Vertical Integration

Abstract This paper examines the effect of quality-improving specific investment rather than cost-reducing specific investment in a vertical relationship. We consider a multi-stage game among two upstream firms and two downstream firms in which firms first make decisions of vertical integration and then upstream firms/divisions choose their investment levels after their choices between general investment and specific investment, and then price decisions of the upstream firms and downstream firms follow sequentially. In the game, the unique equilibrium is for neither pair to integrate and then make specific investments. Making a specific investment is the dominant strategy of upstream firms/divisions under all integration regimes. When only one pair of an upstream firm and a downstream firm is integrated, foreclosure will emerge in equilibrium due to specific investments. Under this integration regime, upstream firms/divisions reduce R&D investments due to lower profits thereby reducing welfare as well, unless the counter-merge emerges. If a counter-merger follows a merger, the merger is likely to be pro-competitive because it restores the R&D incentives and social welfare, and lowers consumer prices, whereas a one-sided integration tends to be anti-competitive if no counter-merger ensues.