Vertical integration: a real options approach

ABSTRACT

We develop a theoretical real options model and explore the trade-off between vertical integration and external procurement. In contrast to transaction cost theory, we show that higher volatility in the downstream market reduces the likelihood to switch to internal production. We also analyse the decision to acquire the supplier and provide novel predictions on the acquisition likelihood and premium contributing to studies relating to vertical M&As.

KEYWORDS:

• Vertical integration
• real options
• optimal timing
• acquisition
• supply chain

JEL CLASSIFICATION:

• G34
• G32

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

¹ Another prominent theoretical view of the boundary of the firm is property rights theory (for a review see Lafontaine and Slade 2007).

² A single buyer client is a realistic assumption in situations where the buyer is a large firm, e.g. a supermarket.

³ The framework can be easily extended to markets where Q is used for the production of another good by introducing a production function for the buyer firm that uses Q as an input.

⁴ The solution follows a similar approach as the one shown in Appendix A and is not shown for brevity.

⁵ Kedia, Ravid, and Pons (2011) focus on cases where both the buyer and supplier have market power since their noisy proxies of market power pick up large gains to vertical integration (see p.848). Similarly, both firms in our model have market power. The supplier exercises market power by applying a mark-up to marginal costs, charging a price p_s>C_s. A higher price p_s charged by the supplier (while keeping C_s constant) implies a higher Lerner index, L = (p_s-C_s)/p_s (see Billette de Villemeur, Ruble, and Versaevel 2014), resulting in a less competitive upstream market. The buyer firm also has market power since it can time the installation of its own input production capacity and interrupt its relation with the supplier (similarly, in Billette de Villemeur, Ruble, and Versaevel 2014, the buyer chooses the optimal investment timing).

⁶ The differential equation is in Dixit and Pindyck (1994), p. 141, equation (9)(9) $K_S^{\ast }=N_0\left(x\right)-B_0\left(x\right)$(9) and is like the one used to price options on dividend paying stocks.:

Additional information

Funding

This work was supported by the Spanish Ministry of Science and Innovation [PID2020-114460GB-C31] and by Fundación Ramón Areces .