Costs of Sales Forces, Substitution between Competing Products, and Vertical Integration Decisions

This paper analyzes duopolistic firms’ vertical integration decisions with considering costs of sales forces and sales delegation under vertical integration. The main contribution of our research is showing that full vertical integration (separation) is more common when competing products are highly (weakly) substitutable. Second, contrary to conventional wisdom, an asymmetric vertical structure may not only be an equilibrium outcome but may also be optimal for consumers’ surplus in spite of yielding higher retail prices than those arising under full vertical integration. We also examine the impacts of vertical structures on welfare which have vertical merger policy relevance. First, when products are weakly substitutable, keeping vertical merger costs low may induce full vertical integration to be an equilibrium outcome which optimizes consumers’ surplus and social welfare simultaneously. Second, imposing a vertical merger tax increasing with substitution between products on firms may induce firms’ vertical integration decisions to be optimal for social welfare.