Investment timing and vertical relationships

Etienne Billette de Villemeur, Richard Ruble and Bruno Versaevel

International Journal of Industrial Organization, 2014, vol. 33, issue C, 110-123

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.

Keywords: Irreversible investment; Preemption; Real options; Vertical relations (search for similar items in EconPapers)
JEL-codes: C73 D92 G31 L13 (search for similar items in EconPapers)
Date: 2014
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (15)

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Working Paper: Investment timing and vertical relationships (2014)
Working Paper: Investment Timing and Vertical Relationships (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:indorg:v:33:y:2014:i:c:p:110-123

DOI: 10.1016/j.ijindorg.2013.06.004

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