Investment Timing and Vertical Relationships

Billette de Villemeur, Etienne and Ruble, Richard and Versaevel, Bruno (2013): Investment Timing and Vertical Relationships. Forthcoming in: International Journal of Industrial Organization

Abstract

We show that the standard analysis of vertical relationships transposes directly to investment dynamics. Thus, when a firm undertaking a project requires an outside supplier (e.g., an equipment manufacturer) to provide it with a discrete input to serve a growing but uncertain demand, and if the supplier has market power, investment occurs too late from an industry standpoint. The distortion in firm decisions is characterized by a Lerner-type index. Despite the underlying investment option, greater volatility can result in a lower value for both firms. We examine several contractual alternatives to induce efficient timing, a novel vertical restraint being for the upstream to sell a call option on the input. We also extend the model to allow for downstream duopoly. When downstream firms are engaged in a preemption race, the upstream firm sells the input to the first investor at a discount such that the race to preempt exactly offsets the vertical distortion, and this leader invests at the optimal time. These results are illustrated with a case study drawn from the pharmaceutical industry.

• Item Type: MPRA Paper
• Language: English
• Keywords: Irreversible investment; Preemption; Real options; Vertical relations
• Subjects: C - Mathematical and Quantitative Methods > C7 - Game Theory and Bargaining Theory > C73 - Stochastic and Dynamic Games ; Evolutionary Games ; Repeated Games; D - Microeconomics > D4 - Market Structure, Pricing, and Design > D43 - Oligopoly and Other Forms of Market Imperfection; D - Microeconomics > D9 - Intertemporal Choice > D92 - Intertemporal Firm Choice, Investment, Capacity, and Financing; L - Industrial Organization > L1 - Market Structure, Firm Strategy, and Market Performance > L13 - Oligopoly and Other Imperfect Markets

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