Vertical Integration with Incomplete Information

Using an independent private values model, we analyze the effects of and incentives for vertical integration. Each firm is characterized by an amount of internally held resources and a maximum demand for these resources as inputs, which determine the firm’s extent of vertical integration, and a distribution for the firm’s private marginal value for resources. After private information is realized, firms trade resources and payoffs are realized. Depending on type realizations, a vertically integrated firm may sell resources to others, buy resources from others, and/or consume resources held internally. A certain extent of vertical integration is necessary and sufficient for the first-best to be possible. With two firms, equilibrium vertical integration is socially optimal but with more firms, vertical integration is typically excessive because of externalities from bilateral transactions. The model provides both rationale and guidance for divestiture after a vertical merger.