Option Contracts in a Vertical Industry

Manel Antelo and Lluis Bru

Manchester School, 2018, vol. 86, issue 4, 533-557

Abstract: We examine the strategic role of horizontal subcontracting through option contracts by a downstream dominant firm competing with a fringe. Downstream production requires an input from imperfectly competitive suppliers. We show that the dominant firm outsources downstream production from fringe firms to gain bargaining clout in the input market. Option contracts are preferred to forwards, because leverage against suppliers is gained at lower contract prices. With no market uncertainty, option contracts do not alter final prices beyond changes caused by unavoidable market power. Whenever demand is uncertain, however, option contracts increase final prices and are therefore harmful for consumers.

Date: 2018
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https://doi.org/10.1111/manc.12204

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Working Paper: Option contracts in a vertical industry (2017)
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