Vertical Integration Under Competition: Forward, Backward, Or No Integration?

Vertical Integration under Competition: Forward, Backward, or No Integration?

Yen-Ting Lin School of Business Administration, The University of San Diego, San Diego, California 92110, [email protected]

Ali K. Parlakturk,€ Jayashankar M. Swaminathan Kenan-Flagler Business School, The University of North Carolina at Chapel Hill, Chapel Hill, North Carolina 27599, [email protected], [email protected]

e consider two competing supply chains, each consisting of supplier, a manufacturer, and a retailer. The suppliers W exert effort to improve product quality, and the retailers sell products competitively. Each manufacturer chooses one of the three strategies: forward integration, backward integration, or no vertical integration. We seek for a subgame perfect Nash equilibrium and study the resulting market structure. Moreover, we characterize the effect of vertical integration on profitability, product price, and quality in a competitive setting. Existing literature has shown that, when manufacturers consider only forward integration, they may choose not to vertically integrate in equilibrium. In contrast, we find that, when both forward and backward integration options are considered, disintegration cannot be an equilibrium outcome. In this case, both manufacturers either forward or backward integrate, and the degree of product perishability, cost of quality, and how much consumers value quality are critical for the chosen direction of integration. Furthermore, competition increases attractiveness of backward integration relative to forward integration. We show that, while integrating backward unilaterally is always beneficial, unilateral forward integration can harm a manufacturer’s profitability. Finally, vertical integration can result in a better quality product sold at a lower price. Key words: vertical integration; competition; supply chain; quality; pricing History: Received: December 2011; Accepted: November 2012 by Eric Johnson, after 2 revisions.

1. Introduction control over the distribution of its growing product offerings (Collier 2009). Conversely, backward inte- Many manufacturers pursue vertical integration to gration stretches a manufacturer’s operations toward gain competitive edge. Examples of vertical conglom- the source of raw materials, strengthening its control erates who govern the entire supply chain are, how- on the supply side. For instance, steelmaker Arcelor- ever, less common. In practice, diversity in the Mittal is moving deeper into the mining business to direction of vertical integration occurs instead: some ensure stable material supply (Worthen et al. 2009); manufacturers choose to forward integrate retail oper- likewise, the Chinese apparel manufacturer Esquel ations, while others opt to backward integrate supply backward integrates supply functions by engaging in activities. This observation immediately leads to an cotton farming (Peleg-Gillai 2007). important question: When should a manufacturer What is driving manufacturers to vertically inte- choose to forward integrate, backward integrate, or grate? Obviously, vertical integration eliminates the stay disintegrated? Furthermore, how do supply adverse effect of double marginalization. However, chain competition and other market and operational forward and backward integrations provide some factors affect this decision? These questions motivate additional benefits. Forward integration allows a this paper. manufacturer to better control its retail price, enabling Forward integration extends a manufacturer’s oper- it to respond to changes in demand more effectively. ational reach to product retailing, tightening its grip The value of this benefit increases with the degree of on the demand side. For example, European fashion product perishability, the rate at which product popu- giant Zara and Los Angeles-based apparel retailer larity changes over time. Such a benefit of forward American Apparel manufacture products and sell integration is quite significant for a fashion apparel them through their own retail channels. Tainan Enter- manufacturer, for example, as it deals with quickly prise, a Taiwan-based manufacturer, established its changing consumer trends. On the other hand, back- own brand, Tony Wear, in China in the late 1990s (Ho ward integration allows a manufacturer to seize a 2002). Similarly, Pepsi purchased its bottlers for better stronger control over its quality of material supply 19 Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition 20 Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society and, thereby, its quality of final products. This occurs In equilibrium, both manufacturers choose to verti- because quality of raw materials is one of the impor- cally integrate in the same direction. The chosen tant determinants of a final product’s quality. For direction depends on how benefits of more closely instance, the quality of fabrics used in its production managing demand and supply side compare to each determines the texture quality of apparel. other. When demand (supply) side dynamics domi- Forward and backward integrations benefit firms in nate, manufacturers choose forward (backward) inte- different ways, and each of these benefits is well gration. On the one hand, when the product is highly understood in isolation. But we want to understand perishable, which implies a significantly lower second when the benefits of forward integration dominate period demand, controlling retail price becomes more those of backward integration, and vice versa. How important. This in turn makes forward integration these benefits interact with competitive dynamics in a more attractive. On the other hand, when return from supply chain is also not clear. These issues lead to a a quality investment is low due to either high cost of number of research questions. When do firms benefit improving quality or low consumer sensitivity, an from vertical integration in a competitive market? independent supplier would underinvest in quality How does the choice between forward and backward too much. Therefore, backward integration, which integration depend on the competitor’s supply chain allows directly controlling quality, becomes more structure? What is the resulting equilibrium supply attractive. chain structure when firms competitively choose their We find that the equilibrium exhibits a prisoner’s integration strategies? Furthermore, how do product dilemma: both manufacturers choose to vertically perishability, consumer sensitivity to quality (market integrate (either backward or forward) in equilibrium, factors), and cost of quality (an operational factor) and they both suffer. Furthermore, competition affect answers to these questions? increases the attractiveness of backward integration To address these questions, we consider a model of relative to forward integration. Specifically, for the two competing supply chains, each consisting of a same demand and cost parameters, a manufacturer is supplier, a manufacturer, and a retailer. The supplier more likely to choose backward integration in duop- can exert effort to improve the quality of material it oly than in monopoly. supplies to the manufacturer. The manufacturer then Moving from disintegration to backward integra- makes the product and sells it through its retailer tion always benefits a manufacturer regardless of its exclusively. The product is sold in two periods, and competitor’s integration strategy. In contrast, integrat- its popularity, and thereby the size of its potential ing forward unilaterally can hurt a manufacturer market, decreases over time. Endogenizing quality because it intensifies the retail competition, which in investment and product perishability in our demand turn drops the retail price and hurts the manufac- model allows us to capture the benefits of vertical turer’s margin. Such a drop is less severe when the integration besides eliminating double marginaliza- competing supply chain has fewer intermediaries. tion. Each manufacturer in our model chooses one of Therefore, when its competitor vertically integrates, a the three strategies: (i) forward integration, (ii) back- manufacturer becomes more likely to choose forward ward integration, and (iii) no integration. We seek a over backward integration. Subgame Perfect Nash Equilibrium (SPNE) in this Controlling the retail end of the supply chain can model. enable improving brand perception. This improve- We find that not to vertically integrate at all cannot ment may increase consumer willingness to pay in be an equilibrium outcome when manufacturers com- some settings. Thus, we also study what happens petitively choose their integration strategies. This when forward integration results in pricing advan- result is in sharp contrast to the celebrated result of tage by reducing consumer price sensitivity. In this McGuire and Staelin (1983), in which disintegration, case, a forward-integrated manufacturer can make that is, not to vertically integrate at all, can be an equi- even the backward integration option unprofitable for librium outcome. The key difference in our model that the competing manufacturer. leads to this contrast is that we consider a three-tier Finally, we show that vertical integration (either supply chain; the manufacturer can choose to either forward or backward) results in a higher quality forward or backward integrate in our model, whereas product sold at a lower retail price. Vertical integra- prior studies allow only forward integration in a two- tion lowers the retail price of a product because it tier supply chain. In other words, we show that the reduces the number of intermediaries profiting from result of prior studies (e.g., Gupta and Loulou 1998, it. This benefit alleviates double marginalization and McGuire and Staelin 1983, Trivedi 1998) is incom- encourages more investment in quality improvement. plete: not to vertically integrate at all can be an equi- In the remainder of this article, section 2 presents librium strategy only when a backward integration our literature review. Section 3 describes our model. option is not available. Section 4 characterizes the equilibrium decisions and Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society 21 discusses the value of vertical integration. Section 5 less likely to drop when the merger occurs in down- presents extensions to the base model. Finally, section stream rather than upstream of a supply chain. Pun 6 offers our concluding remarks. and Heese (2010) consider two competing manufacturers who sell two complementary products through 2. Related Literature retailers, and they find that manufacturers can benefit from staying disintegrated, as this mitigates their A number of papers in Operations Management and competition. Boyaci and Gallego (2004) consider two Marketing literature study the structure of competing supply chains who compete on fill-rate assuming an supply chains. In their seminal work, McGuire and exogenously determined retail price. In contrast firms Staelin (1983) consider two competing supply chains, compete on price and quality in our model. They and they show that staying disintegrated can be an identify a prisoner’s dilemma: both supply chains equilibrium for manufacturers. A number of papers prefer having coordination among its manufacturer have extended this result, confirming that vertically and retailer even though both achieve a lower profit. integrating with a downstream retailer may not be the There is a stream of papers addressing when a firm profit-maximizing strategy for a manufacturer under should outsource production or keep it in-house, various settings. For example, Moorthy (1988) finds which is essentially a form of backward integration. that manufacturers may not vertically integrate even Cachon and Harker (2002) and Gilbert et al. (2006) when competing products are complements. Cough- show that competing firms may benefit from out- lan (1985) extends the linear demand model of sourcing production to a common supplier as this McGuire and Staelin (1983) to a more general demand dampens the price competition. In our model, each model. Trivedi (1998) allows retailers to carry prod- manufacturer has a distinct supplier instead of a com- ucts of multiple competing manufacturers. In Gupta mon one. Van Mieghem (1999) and Kostamis and and Loulou (1998), manufacturers can invest in Duenyas (2009) allow firms to continue producing research and development to reduce unit production in-house while outsourcing a part of their production. cost. In Gupta (2008), a manufacturer’s cost reduction Our paper differs from the aforementioned papers investment also helps its competitor reduce its cost in three critical aspects. First, while we study a three- due to involuntary technology spillovers. In Liu and tier supply chain, they all consider vertical integration Tyagi (2011), retailers determine their competitive in two-tier supply chains, and therefore they cannot product position on a Hotelling line. Wu et al. (2007) address the choice between forward and backward allow for demand uncertainty. They show that integration. Second, our paper differs in that the prod- whether demand variability affects the equilibrium uct quality is endogenously determined. Finally, there supply chain structure depends on the form of the are two periods which allow capturing the product demand probability distribution function: when it perishability. These elements enable us to capture takes a certain form, higher variability favors vertical quality and pricing benefits of vertical integration, integration. and they are critical to our research questions and All of these papers show that McGuire and Staelin’s their results; dropping any of them leads to trivial (1983) disintegration result continues to hold in vari- outcomes. ous scenarios; in contrast we show that the disintegra- Another relevant line of papers studies the channel tion result does not hold in our model. The key conflict that arises when a manufacturer competes difference that leads to this contrast is that these with its retailer by directly selling to consumers, papers, including McGuire and Staelin (1983), con- which is a form of forward integration. These papers sider two-tier supply chains and they allow only for- explicitly model the consumer choice between chan- ward integration, whereas our model considers a nels. They consider attributes like product availabil- three-tier supply chain allowing both forward and ity, delivery lead time, and relative inconvenience of backward integrations. each channel (Chen et al. 2008) and consumer cost for Corbett and Karmarkar (2001) show that when two searching online or traveling (Cattani et al. 2006, Guo competing supply chains both adopt vertical integra- and Liu 2008) in addition to prices. In these papers, tion, they both suffer a drop in their profitability. the manufacturer decides whether to add a direct However, Corbett and Karmarkar (2001) do not study channel to compete with its independent retailer; the whether firms would choose vertical integration in structures of the channels, however, are fixed. In con- equilibrium; in contrast, we study the vertical integra- trast, in our paper, there are already two competing tion strategies manufacturers choose in equilibrium. channels, and each one determines its structure by Cho (2011) extends Corbett and Karmarkar (2001) by deciding whether to integrate vertically. Furthermore, studying horizontal merger among firms within the these papers study competition within the supply same tier of a supply chain, whereas we focus on ver- chain of the same product produced by the same tical integration. Cho (2011) finds that retail price is manufacturer, that is, competing products are Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition 22 Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society identical. In contrast, competing supply chains inde- Table 1 Parameters and Decision Variables pendently determine the quality of their products in Symbol Definition our model. t Time period Our work also relates to papers that study joint k Size of consumer population in the second period quality and pricing decisions in a vertically disinte- m € Consumer reservation value grated supply chain. Kaya and Ozer (2009) find that a Consumer quality sensitivity vertical disintegration by outsourcing production to a d Consumer disutility per unit deviation from the ideal product i contract manufacturer whereby the contract manufac- wi;t Distance between product and a consumer’s ideal product in period t turer decides product quality results in a lower qual- hi Quality of product i ity product similar to our results. However, they find ri Raw material price charged by supplier i that vertical disintegration results in a lower price wi Wholesale price charged by manufacturer i contrary to our findings. This contrast is due to a pi;t Retail price of product i in period t € Q i t difference in the sequence of events. In Kaya and Ozer i;t Sales quantity of product in period c Cost coefficient for quality improvement (2009), the downstream firm dictates the wholesale N,F,B No integration, forward integration, and backward integration price by offering a two-part tariff contract before the respectively upstream firm chooses the product quality, whereas Ii Manufacturer i’s vertical integration strategy c cd in our paper the upstream firm dictates the wholesale a2 price after choosing product quality, which leads to a € higher wholesale price. Thus, in Kaya and Ozer (2009), the downstream firm can affect the upstream Following Salop’s (1979) spatial differentiation firm’s quality choice through its contract terms, and model, we assume consumers are utility maximizers not knowing the upstream firm’s cost or inability to 1 and they are uniformly distributed along a circle at 2 contract on quality hurts the efficiency of its contract. 1 units of density in each period. Each consumer is In contrast, in our model the downstream firm can identified by a point on the circle which represents affect the product quality only by vertically integrat- her ideal product. The two competing products are ing with the upstream firm. Furthermore, when con- 2 located at the two ends of the diameter. Each cus- sidering vertical integration, firms need to take into tomer stays in the market only for one period, and a account the competitor’s reaction. Our focus is on new batch of customers arrives in the next period. If quantifying the impact of competition on vertical inte- buying a product yields nonnegative utility, the cus- gration, whereas their focus is on quantifying the tomer purchases one unit of the product that gives effect of quality risk due to asymmetric quality cost her the highest utility. Here information and non-contractable quality in vertical ; ; disintegration. Similarly, Gilbert and Cvsa (2003) and Uðhi pi;t wi;tÞ¼m þ ahi pi;t dwi;t ð1Þ Xu (2009) also consider joint quality and pricing decisions in a disintegrated supply chain, but they too do shows the utility from purchasing product i (i.e., the not consider competition and their focus is different. product of supply chain i) in period t, where m In Heese (2010), a retailer sells its own store-brand shows consumer reservation value, hi represents the product in addition to the competing product of a quality of product i, and pi;t is the retail price of national manufacturer, where both the retailer and product i in period t. Here, a captures consumer manufacturer choose the quality of their products. sensitivity to product quality. We fix the consumer Finally, vertical integration can eliminate double price sensitivity, that is, the coefficient to pi;t in marginalization and achieve coordination, which is a Equation (1), to 1. However, we relax this assump- very important issue for supply chains. There is quite tion and present additional insights in section 5.1. a rich literature on this subject, and Cachon (2003) Finally, w ; is the shortest distance between product € i t and Kaya and Ozer (2012) provide excellent reviews i and the consumer’s ideal product as Figure 1b of this literature. illustrates, and a consumer incurs disutility d > 0 per unit of distance. 3. Model The product popularity decreases over time. Spe- cifically, the mass of potential customers, that is, We consider two competing supply chains (i = 1,2) market size, in period 1 is normalized to 1, but it selling products to a consumer market over two peri- shrinks to k < 1 in period 2. Thus, in t = 2, there are ods (t = 1,2). In the following, we introduce our con- fewer consumers and they are distributed on a sumer choice model, firm decisions and cost smaller circle, as seen in Figure 1a. In other words, structure, and vertical integration choices. Table 1 differentiation between the products gets smaller in summarizes the parameters and decision variables of period 2. This approach assumes that customers our model. who buy a product in period 2 do not have strong Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society 23

Figure 1 Consumer Demand Model

(a) (b)

preferences between the products (relative to period (Peleg-Gillai 2007). Similarly, advances in spinning 1 customers), and the price becomes a relatively and knitting technologies improve the production more important factor. process, allowing yarns to produce fabrics with supe- Here, k measures the demand perishability: a smal- rior quality (Bainbridge 2009). In addition, to keep ler k indicates a faster decrease in the product popu- our focus on the impact of vertical integration, we larity over time; thus the demand perishability is assume firms do not incur variable costs for produc- proportional to 1 k. The demand perishability plays tion and retailing, and they have sufficient capacity to a critical role in the manufacturers’ forward integra- fulfill any demand. tion decisions. Specifically, a smaller k corresponding As will be evident, the fact that quality is endo- to highly perishable demand makes directly control- genously determined plays a critical role in the manu- ling the price through forward integration more valu- facturers’ backward integration decisions in our able, as it allows responding to changes in demand model. Backward integration enables a manufacturer better.3 to better coordinate quality choice in its supply chain Each supply chain i consists of a supplier ðSiÞ,a by directly controlling quality decision, but the manu- manufacturer ðMiÞ, and a retailer ðRiÞ, and all firms facturer needs to absorb the quality investment cost. are risk neutral profit maximizers. A supplier pro- In fact, Appendix B shows that when the quality vides raw materials to its downstream manufacturer investment cost disappears, backward integration is at a unit material price ri, which is determined by the always preferred. Furthermore, vertical (both forward supplier. Supplier i invests in material quality, which and backward) integrations create an additional in turn determines the product quality hi. Manufac- dynamic due to endogenous quality: reduction in turer i produces each product i with one unit of raw double marginalization incentivizes further invest- material and sells it to retailer i at its chosen unit ment in quality, and this in turn can lead to an addi- wholesale price wi. Finally, retailer i determines the tional benefit from vertical integration. retail price pi;t for product i, in each period t, and sells While a number of studies including ours treat it in the consumer market. quality improvement as a fixed cost investment (e.g., The material price r and wholesale price w do not Bhaskaran and Krishnan 2009, Bonanno 1986, Demir- i i € change across periods because firms often sign rela- han et al. 2007, Kaya and Ozer 2009), there are others tively long-term contracts with their suppliers; long- assuming quality improvement accompanies an term contracts are common in B2B settings in many increase in marginal production cost. Both examples industries such as textile, computer hardware, tele- are prevalent in practice, and our model considers a communication, mining, and energy (AT&T 2012, setting in which quality is improved by a one-time Hachman 2012, Saigol 2012).4 In contrast, we allow investment characterized by a fixed cost. the retail price pi to be adjusted from period to period, As Figure 2 indicates, we envision three integration reflecting the fact that a retailer has more flexibility in strategies for each manufacturer: no integration (N), pricing. forward integration (F), and backward integration (B). 2 Supplier i incurs a fixed cost chi for achieving qual- When a manufacturer does not integrate, its material ity level hi, where c determines how expensive it is to supply and product retail are accomplished through improve quality. This assumes quality improvement other independent firms. In that case, the manufac- is achieved through process improvement. Indeed, it turer has control only over the wholesale price it is not uncommon to see quality improvement exam- charges to the retailer. When a manufacturer forward ples as fixed cost investments in practice. For exam- integrates, it sells the product through its own com- ple, Esquel, a major Chinese apparel manufacturer, pany stores and controls the retail price pi. Finally, provides its cotton suppliers training in process when a manufacturer backward integrates, it per- improvement techniques, such as seed selection and forms supply operations in-house and controls the impurities elimination, to improve cotton quality quality level hi. Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition 24 Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society

Figure 2 Vertical Integration Choices

When a manufacturer is indifferent between the quality differentiation relatively less important com- integration options, we break the tie in favor of no pared to the spatial differentiation. integration over integration and forward over back- Furthermore, we make the following two paramet- ward integration. This refinement does not affect our ric assumptions to keep our focus on the interesting insights. We follow this convention for ease of exposi- scenarios and avoid trivial cases. These assumptions tion; otherwise multiple equilibria exist at the bound- are only for ease of exposition; relaxing them, while ary points of equilibrium regions. We use Ii 2 adding additional equilibrium regions, does not fN; F; Bg to denote manufacturer i’s integration strat- change our insights. egy, and I I to denote different scenarios of supply 1 2 A1. m [ dð3ð5þ4kÞ 1þkÞ; otherwise the market is chain structures in the industry. 2 6c not covered, and firms do not compete, forming Let Qi;t be the sales quantity of product i in period t. N local monopolies. Then the profit functions for the retailer p , manufac- 9c Ri A2. ð11 1Þ [ 1; otherwise in an asymmetric turer pN , and supplier pN in a disintegrated supply 4 k Mi Si competition, a disintegrated supply chain com- chain i are peting against a vertically integrated supply X2 chain cannot sell any products in period 2. N p ¼ ðpi;t wiÞQi;t; ð2Þ Ri Assumption A2 avoids this trivial case by ensuring t¼1 that the market size in period 2 is sufficiently large (i.e., X2 large k) and the relative return from quality investment N p ¼ðw r Þ Q ; ; ð Þ Mi i i i t 3 is not too high (i.e., large c) so the advantaged vertically t¼1 integrated supply chain cannot drive its disadvantaged

X2 competitor out of market in period 2. N 2 p ¼ r Q ; ch : ð Þ The sequence of decisions is as follows: first, each Si i i t i 4 t¼1 manufacturer chooses its vertical integration strategy, which determines the supply chain structure I1I2 of the When manufacturer i forward integrates, it sets the industry. Then, firms who control the material supply retail price itself. In this case, the profit function for (a supplier or a backward-integrated manufacturer) manufacturer i becomes competitively determine their quality levels. These

X2 firms then set the unit price they charge to their down- F p ¼ ð ; Þ ; : ð Þ stream customers. Thereafter, a manufacturer sets its Mi pi t ri Qi t 5 t¼1 wholesale price if it does not vertically integrate. Finally, the selling season begins, and firms that sell On the other hand, backward integration allows products to consumers (a retailer or a forward-inte- manufacturer i to dictate its quality level. This yields grated manufacturer) set their retail prices for each the following profit function for manufacturer i: period and demand is realized. We seek a SPNE of this game. When there are multiple equilibria, we eliminate X2 B 2 p ¼ ; h : ð Þ the ones that are Pareto dominated by another equilib- Mi wi Qi t c i 6 t¼1 rium in the sense of resulting in lower payoffs for all parties. Specifically, there are multiple equilibria in To facilitate our discussion, we define xþ ¼ only one scenario and it is explicitly stated in our dis- maxðx; 0Þ and cussion of equilibrium results. This approach is for cd ease of exposition and it does not affect our key find- c ¼ : ð7Þ a2 ings. Our sequence of events is consistent with the notion Essentially, c is a measure of relative return from that quality decisions are made before pricing deci- quality investment, and a high c due to either high sions as they need more advanced planning (Banker cost of quality c or low consumer sensitivity to quality et al. 1998, Chambers et al. 2006, Desai 2001, Xu 2009). a indicates low return from a quality investment. Furthermore, it is common to assume that upstream Likewise, a high d, which yields a high c, makes firms move before downstream firms in studying Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society 25 vertical integration and the structure of supply chains main model allows us to extract the impact of compe- (Corbett and Karmarkar 2001, Gupta and Loulou tition. When the monopolist supply chain serves the 1998, McGuire and Staelin 1983, Wu et al. 2007). We entire market, vertical integration cannot increase its follow this convention so our results can be con- demand (it has no impact on the quality and retail trasted with these studies. price as well). Thus, we confine our monopoly benchmark to regions in which the manufacturer is not limited by the market size in both periods, which is 4. Equilibrium and Vertical Integration \ dk 5 ensured by m c ð4c 1Þ. Together with assump- First, we describe how we derive the equilibrium. We tion A1, this means that the market is sufficiently big then demonstrate the monopoly benchmark. Subse- for a single firm so there is potential for increasing quently, we present price–quality equilibrium for two sales, but sufficiently small for two firms so they competing supply chains for all possible supply chain compete. structures I1I2. By comparing our results across different supply chain structures, we quantify the value of PROPOSITION 1. Consider a monopolist supply chain. forward and backward integration, which also allows characterizing the vertical integration equilibrium. (i) There exists a unique SPNE, and the equilibrium Proofs for all of our analytical results are provided in decisions are described in Appendix A. the online Appendix. (ii) The manufacturer and the entire supply chain always achieve higher profits when the manufac- 4.1. Characterization of Equilibrium turer moves from disintegration (N) to forward (F) When none of the manufacturers vertically integrate or backward (B) integration. (NN), a SPNE satisfies the following for i = 1, 2 and t = 1, 2: Vertical integration eliminates double-marginalization. It can improve sales only when the market is not X2 2 already covered. In this case, it always increases prof- h ¼ arg max r Qi;tðh; p ðr ; hÞÞ ch ; ð8Þ i h i i itability of the manufacturer and the entire supply i t¼1 chain. X2 Now we return our focus to duopolist supply ; ; 2; r ¼ arg max ri Qi;tðh p ðr hÞÞ ch ð9Þ chains. In this case, firms need to take both its compet- i r i i t¼1 itor’s and downstream partner’s actions into account

X2 when making decisions. w ¼ arg maxðwi riÞ Qi;tðh; p ðwÞÞ; ð10Þ i w i t¼1 LEMMA 1. Consider two competing supply chains. There is a unique SPNE of price-quality competition in all sup- X2 ply chain scenarios I I ,I2fN; F; Bg. Equilibrium ; : 1 2 i pi ¼ arg max ðpi;t wiÞQi;tðh pÞ ð11Þ p ; ;p ; product quality hi, retail price pi;t, and total sales quan- i 1 i 2 t¼1 tity Qi for each scenario are as follows. – Problems (8) (11) formulate the optimization prob- (i) When none of the manufacturers vertically inte- lems for the suppliers, manufacturers, and retailers. grates, NN, Essentially, problems (8) and (9) state that each supplier chooses the quality and material price to ð1 þ kÞa h ¼ h ¼ ; maximize its profit. Problem (10) indicates that each 1 2 6c manufacturer sets the wholesale price to maximize its p1;1 ¼ p2;1 ¼ dð7 þ 6kÞ; profit. Finally, Problem (11) states that each retailer p ; ¼ p ; ¼ dð6 þ 7kÞ; maximizes its profit by setting the retail price. 1 2 2 2 1 þ k When manufacturer i vertically integrates, it no Q1 ¼ Q2 ¼ : longer solves problem (10), and a new problem arises: 2 when manufacturer i forward integrates, it sets retail prices and solves problem (11) with wi replaced by ri. (ii) When only manufacturer 1 forward or backward Alternatively, when manufacturer i backward inte- integrates, FN or BN, grates, it determines its quality hi, solving problems (8) and (9) with ri replaced by wi. We derive the equi- ð1 þ kÞð63c 2Þa ; librium by applying backward induction, essentially h1 ¼ 12cð27c 1Þ solving problems (8)–(11) in reverse order. dð9cð55 þ 43kÞ4ð4 þ 3kÞÞ Let us first consider a monopolist supply chain as a p1;1 ¼ ; benchmark; contrasting this benchmark with our 4ð27c 1Þ Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition 26 Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society

dð9cð43 þ 55kÞ4ð3 þ 4kÞÞ Recall that vertical integration always benefits a p ; ¼ ; 1 2 4ð27c 1Þ monopolist manufacturer (Proposition 1). In contrast, the next proposition shows that vertical integration ð1 þ kÞð63c 2Þ ; Q1 ¼ can actually harm profitability in a competitive 4ð27c 1Þ setting. ð1 þ kÞð45c 2Þa h ¼ ; 2 12cð27c 1Þ LEMMA 2. dð18cð14 þ 11kÞð11 þ 9kÞÞ ; p2;1 ¼ (i.a) PFN PNN if and only if k d . 2ð27c 1Þ M1 M1 1 (i.b) PFI2 PNI2 for I 2fF; Bg if and only if dð18cð11 þ 14kÞð9 þ 11kÞÞ M1 M1 2 p2;2 ¼ ; 2ð27c 1Þ k d2. PBI2 [ PNI2 ; ; ð1 þ kÞð45c 2Þ (ii) for I2 2fF N Bg. : M1 M1 Q2 ¼ ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi 4ð27c 1Þ p 2ð8396c þ 4779c2Þþ4ð27c 1Þ ð8396c þ 4779c2Þþ Here, d1 ¼ 1 2 4180c þ 1863pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffic (iii) When both manufacturers forward or backward c c2 þ c c c2 þ and d ¼ 1 2ð8324 þ 3159 Þ 4ð27 1Þ ð8324 þ 3159 Þ . integrate, FF, BF, FB, or BB: 2 4108c þ 243c2 In addition to enabling direct control on quality ð1 þ kÞa and price, vertical integration reduces double margin- h ¼ h ¼ ; 1 2 6c alization in a supply chain. Therefore, one may expect dð5 þ 3kÞ it to improve profitability. However, in a competitive p ; ¼ p ; ¼ ; 1 1 2 1 2 market, vertical integration intensifies the price com- dð3 þ 5kÞ petition, which could negate its benefits. The manu- p ; ¼ p ; ¼ ; 1 2 2 2 2 facturer feels the competitive effect more strongly when it forward integrates, as it moves closer to price 1 þ k : Q1 ¼ Q2 ¼ competition. Therefore, while backward integration 2 always benefits a manufacturer, as part (ii) illustrates, forward integration can be detrimental as shown in When only manufacturer 1 is vertically integrated, parts (i.a) and (i.b). The benefit of forward integration Lemma 1(ii) states that FN and BN scenarios share the depends on the level of demand perishability mea- same equilibrium quality, price, and sales quantity sured by k. Specifically, a small k indicates a bigger outcomes. This is because the sequence of events and drop in the market size (i.e., the mass of potential cus- decisions are identical in these scenarios. Manufac- tomers) in period 2, which makes the ability to turer 1, however, achieves different profits. In the BN directly control pricing by forward integration more scenario, it collects the profit of a supplier in a two- valuable. Thus, when k is sufficiently small, the bene- tier supply chain, whereas it collects the profit of a fit of forward integration dominates. retailer in the FN scenario. Likewise, when both man- The previous lemma discusses the value of vertical ufacturers are vertically integrated as in Lemma 1(iii), integration when the manufacturer moves from disin- FF, BF, FB, and BB scenarios have the same equilib- tegration to vertical integration. The next proposition rium quality, price, and sales quantity outcomes. examines the choice between forward and backward Consistent with the sequence of events, it is straight- integration. forward to show that the supplier’s margin is higher than the manufacturer’s, which is in turn higher than LEMMA 3. the retailer’s in a disintegrated supply chain (this is (i) PBN [ PFN. also true in monopoly benchmark). M1 M1 (ii) PFI2 PBI2 [ PFN PBN for I 2fF; Bg. M1 M1 M1 M1 2 4.2. Vertical Integration Equilibrium PFI2 PBI2 ; (iii) for I2 2fF Bg if and only if k d3. – M1 M1 Having characterized price quality equilibrium, we pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi now turn our focus to the choice of vertical integra- 2ð18c1Þþ6 cð18c1Þþ Here d3 ¼ 1 . tion strategies and their impact on profitability. Spe- 9c1 cifically, in the following, Lemmas 2 and 3 show the Because forward integration intensifies the impact value of forward and backward integration in a com- of competition more than backward integration for petitive market, and then Proposition 2 describes the the manufacturer, backward integration always domi- chosen vertical integration strategies in equilibrium. nates forward integration against a disintegrated Let PI1I2 be the equilibrium profit of manufacturer 1 competitor as in part (i). However, when the compet- M1 when manufacturer i, i = 1,2, chooses strategy Ii. ing supply chain is vertically integrated, its price Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society 27 reaction is weaker due to fewer firms adjusting their The proposition shows that symmetric manufactur- margins. Thus, a vertically integrated competitor ers make symmetric choices. However, section 5.4 improves the relative attractiveness of forward inte- shows that the cost asymmetry can lead to asymmet- gration as shown in part (ii). Indeed, when the com- ric equilibrium outcomes. Parts (i) and (ii) provide petitor is vertically integrated, forward integration benchmarks in which only one of the integration can dominate backward integration as part (iii) dem- options is available. Their results immediately follow onstrates. from Lemmas 2 and 3. Specifically, backward integra- The result in part (iii) depends on how benefits of tion is always desirable, whereas a smaller k indicat- controlling price and quality compare to each other. ing higher degree of demand perishability makes Recall that a high c, which is defined in Equation (7), forward integration desirable.8 indicates a lower return on quality investment. Part (iii) states the equilibrium for our main Moreover d3 is decreasing in c, thus a lower d3 model. It shows that staying disintegrated cannot be means a lower return from quality investment. an equilibrium outcome when the manufacturers Therefore, when d3 is low, an independent supplier consider both forward and backward integration would underinvest in quality too much. Doing so options. This is in sharp contrast to the celebrated increases the attractiveness of backward integration result that disintegration can be an equilibrium out- for the manufacturer, as it allows directly controlling come (e.g., Gupta and Loulou 1998, McGuire and quality. Staelin 1983, Trivedi 1998). The key difference is that In contrast, when d3 is high, quality investment in those studies the manufacturers can choose becomes attractive. The suppliers overinvest in qual- among no integration and forward integration (the ity due to competition; thus the manufacturers do not backward integration option is not available) as in need to control quality. Furthermore, overinvestment part (ii). Not surprisingly, their findings are consis- in quality hurts the suppliers’ profitability, which tent with our part (ii) benchmark. gives the manufacturers another reason to stay away Part (iii) demonstrates that both manufacturers from backward integration.6 On the other hand, a low choose to vertically integrate in the same direction in k indicates a bigger intertemporal drop in market size, equilibrium. Consistent with Lemma 3, the chosen and this in turn makes controlling price through for- direction depends on how benefits of more closely ward integration desirable. The overall effect depends controlling demand and supply side compare to each 7 on how k compares to d3 as shown in part (iii). To other. When k is small, indicating higher degree of sum up, Lemma 3 shows that the choice between for- demand perishability, there is bigger need for control- ward and backward integration critically depends on ling price, whereas when d3 is small, indicating low the structure of the competing supply chain, return return from quality investment, the need for control- on quality investment, and the degree of demand per- ling quality prevails. ishability. Note that when k = 1, demand is no longer perish- Having characterized each manufacturer’s best able, and both periods become identical; thus the response integration strategy in Lemmas 2 and 3, now products are sold at the same price in each period. In we are ready to state integration strategies I1I2 the this case, the model becomes similar to a single-period manufacturers choose in equilibrium. model, yielding the same equilibrium structure as in Proposition 2, but quality investment becomes the only dynamic determining the equilibrium outcomes.9 PROPOSITION 2. The next proposition reveals that the equilibrium in (i) When manufacturers can choose among no integra- part (iii) of Proposition 2 results in a prisoner’s tion (N) and backward integration (B), I1I2 ¼ BB. dilemma. (ii) When manufacturers can choose among no integra- PNN [ PFF PNN [ PBB tion (N) and forward integration (F), then PROPOSITION 3. M M and M M . 1 1 1 1 \ ; FF for k d1 In equilibrium, both manufacturers vertically inte- I1 I2 ¼ : NN otherwise grate, and they both suffer due to competing with a stronger competitor. Observe that when the backward (iii) When manufacturers can choose among no integra- integration option is not available (i.e., in the setting tion (N) and both forward (F) and backward (B) of McGuire and Staelin 1983), the equilibrium does integration, then not necessarily lead to a prisoner’s dilemma, as no FF for k d ; integration can be an equilibrium outcome. II ¼ 3 1 2 BB otherwise; Proposition 2 characterizes the equilibrium under competition. It is worthwhile to contrast its results where d1, d2, and d3 are given in Lemmas 2 and 3. with the monopoly benchmark (Proposition 1) to see Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition 28 Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society

I1I2 \ NI2 I1I2 \ NI2 I1I2 \ NI2 how competition affects the chosen vertical integra- (ii) Q2 Q2 , h2 h2 , and p2;t p2;t , for ; ; ; tion strategy. I1 2fF Bg and any I2 2fF N Bg. I1I2 NN I1I2 NN I1I2 \ NN (iii) Qi ¼ Q1 , hi ¼ h1 , and pi;t pi;t , for COROLLARY 1. The manufacturers are more likely to Ii 2fF; Bg and i = 1,2. choose backward integration under duopoly competition compared with the monopoly benchmark. Interestingly, Proposition 5(i) shows that manufacturer 1’s vertical integration (both forward and back- Forward integration increases the intensity of price ward) results in a better quality product 1 sold at a competition more than backward integration. A lower retail price in both periods. Because vertical monopolist does not need to worry about the price integration alleviates double marginalization, it reaction of the competitor and more freely integrates encourages more quality investment for product 1, forward whereas the competitor’s response is an issue which can potentially increase the retail price. On the for a duopolist. Therefore, a manufacturer is more other hand, vertical integration removes intermediaries likely to choose backward integration in duopoly than who add their margins to the retail price, and this leads in monopoly. to an opposite force that can lower the retail price. So far we have showed that vertical integration can Similarly, vertical integration forces the competitor to hurt a manufacturer. An immediate question becomes drop its prices. This reaction intensifies the price com- how it affects the entire supply chain. The next propo- petition, which can also lead to a lower retail price. As sition addresses this question. Let PI1I2 be the total C1 a result, the latter forces dominate, and the quality of equilibrium profit achieved by supply chain 1 when product 1 improves while its retail price drops. Part (ii) manufacturer i, i = 1,2, chooses strategy I . i shows that the competitor decreases its quality investment because it now faces a stronger opponent (one PROPOSITION 4. with less double marginalization inefficiency). (i) PFI2 \ PNI2 and PBI2 \ PNI2 for any I . Finally, part (iii) compares what happens when C1 C1 C1 C1 2 II both of the manufacturers vertically integrate to (ii) P 1 2 PNN. C1 C1 when none of them do so. The retail prices are lower when they vertically integrate due to more intense Part (i) shows that both forward and backward inte- competition. Furthermore, because no supply chain grations decrease profitability of the supply chain. has the advantage, they equally split the market and Thus, even when the manufacturer benefits from choose the same product quality in both scenarios. vertical integration (as shown in Lemmas 2 and 3), this happens at the expense of its supply chain partners. Note that the adverse effect of vertical integra- 5. Extensions tion is due to the competitor’s reaction because in monopoly benchmark vertical integration always In this section, we consider various extensions of our improves a supply chain’s total profit. model. Section 5.1 allows forward integration to alter Proposition 3 indicates that the equilibrium results consumer price sensitivity; section 5.2 allows manu- in a prisoner’s dilemma for manufacturers. Part (ii) of facturers to modify the wholesale price in period 2; Proposition 4 shows that both supply chains suffer in section 5.3 studies retailers’ quality contribution; equilibrium as well. The equality in this case occurs finally, section 5.4 allows suppliers to differ in their when none of the manufacturers vertically integrate quality improvement costs. (i.e., I1 I2 ¼ NN); otherwise supply chain profits decrease strictly when equilibrium involves vertical 5.1. Forward Integration and Price Sensitivity integration. So far we have assumed vertical integration does not alter the consumer price sensitivity. In this section, we relax this assumption and consider what happens 4.3. Impact on Product Quality, Sales Quantity, when forward integration reduces the consumer price and Retail Price sensitivity. Intuitively, direct contact with consumers The previous section has focused on the impact of through company stores can generate better brand vertical integation on profitability. Here, we discuss perception, which can increase consumers’ willing- the impact on sales quantity, product quality, and ness to pay. Indeed, it is common to see higher retail retail price. prices in company stores than in general retailers, and some examples are provided in Table 2.10 PROPOSITION 5. For t = 1,2,

I1I2 [ NI2 I1I2 [ NI2 I1I2 \ NI2 (i) Q1 Q1 , h1 h1 , and p1;t p1;t , for 5.1.1. Symmetric Price Sensitivity. Suppose man- ; ; ; I1 2fF Bg and any I2 2fF N Bg. ufacturers enjoy equal reduction in the consumer price Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society 29

Table 2 Difference in Retail Prices First, we present new findings regarding the value Company of vertical integration to a manufacturer. store Private Retailer Product price retailer price PROPOSITION 6. Columbia Steep Slop $181.90 REI $139.93 (i) PFI2 [ PNI2 if and only if bF \ sI2 for M1 M1 1 Parka Men’s Ski Jacket ; ; I2 2fF N Bg. North Face Denali $199 Dick’s Sporting $178.99 PFI2 [ PBI2 F \ I2 (ii) M M if and only if b s2 for Thermal Women’s Goods 1 ; ; 1 Jacket I2 2fF N Bg. (iii) PBF \ PNF if and only if bF \ s ; PBI2 [ PNI2 Nike Dri-Fit UV Men’s $70 Dick’s Sporting $65 M1 M1 3 M1 M1 Stripe Golf Polo Goods for I2 2fN; Bg. Apple iPod Nano 5th Gen $149 Walmart $133.99 I2 I2 8GB The thresholds s1 , s2 , and s3 are characterized in the Sony DSC-T90 Digital $279 Walmart $248 proof in online Appendix E. Camera When forward integration improves a manufacturer’s pricing advantage, manufacturers are more sensitivity when they forward integrate. Specifically, likely to adopt this strategy. Consequently, forward I integration can be beneficial, and it can be favored let bi be the consumer price sensitivity to product i when manufacturer i chooses strategy I, I ∈ {F,N,B}. over backward integration when the pricing advan- Then the base model described in section 3 entails tage is significant, as in Proposition 6(i) and Proposi- tion 6(ii). bI ¼ 1, I ∈ {F,N,B}, i = 1,2, as Equation (1) shows. In i Proposition 6(iii) demonstrates an additional this section, we relax that assumption, allowing insight: the potential benefit of backward integration bF ¼ bF \ bI ¼ ∈ { } = i 1 while keeping i 1, I N,B , i 1,2. can be nullified by the competitor’s pricing advan- F \ Furthermore, to account for b 1, we generalize tage. This is in direct contrast to our base model F F assumption A2 as 9cb ð11 1Þ [ 1 b 1 , which where backward integration is always beneficial. 3þbF k kð3þbFÞ When manufacturer 2’s pricing advantage from for- reduces to the original A2 when bF ¼ 1. We assume ward integration is significant, it relies on this advan- that the price sensitivity advantage of forward integra- tage and reacts to manufacturer 1’s backward bF [ 1þ3k tion is not extreme, specifically 1 kþ54ck, to avoid integration by increasing the quality of its product. the trivial case in which a backward-integrated supply This in turn decreases manufacturer 1’s return from chain competing against a forward-integrated supply quality investment when it backward integrates. chain cannot sell any products in a period. We present Next, we formally state that staying disintegrated the resulting equilibrium quality, price, and sales cannot be an equilibrium outcome when manufactur- quantity for all possible supply chain configurations ers competitively determine their vertical integration in Appendix C. strategies. While our discussion in the following will focus on F \ new findings due to relaxing bF ¼ 1, we want to PROPOSITION 7. When b 1 and manufacturers choose point out that most of the key results of the base among no integration (N), forward (F), and backward (B) model continue to hold. Specifically, Proposition 6 integration, then NN cannot be an equilibrium. shows vertical integration can be detrimental to a manufacturer, which is consistent with Lemma 2. This occurs because backward integration does not Proposition 6 also characterizes the conditions that affect the consumer price sensitivity. Thus, when a make forward integration more attractive than back- manufacturer chooses to stay disintegrated (N), its ward integration similar to Lemma 3. Proposition 8 competitor can always improve its profitability by shows vertical integration can improve product qual- backward integration, as Lemma 2 shows. Finally, we ity while reducing the retail price as in Proposition 5. examine the effect of vertical integration on product However, allowing bF \ 1 complicates the analysis; quality and sales quantity. characterizing equilibrium vertical integration strate- PROPOSITION 8. Let I ; I 2fF; N; Bg: gies as in Proposition 2 becomes intractable. This diffi- 1 2 ; ; I1I2 \ NI2 I1I2 \ NI2 culty arises because the profit expressions involve (i.a) For ðI1 I2Þ¼ðB FÞ: h1 h1 ,Q1 Q1 , high order polynomials, and characterizing equilib- I1I2 [ NI2 I1I2 [ NI2 h2 h2 , and Q2 Q2 if and only if rium regions requires comparing multiple high order bF \ 4 . polynomials. Even though we cannot fully character- 2þ27c (i.b) For ðI ; I Þ 6¼ðB; FÞ: hI1I2 hNI2 ,QI1I2 QNI2 , ize equilibrium integration strategies, Proposition 7 1 2 1 1 1 1 hI1I2 hNI2 I1I2 NI2 confirms that no integration still cannot be an equilib- 2 2 , and Q2 Q2 . F \ FI2 [ NI2 F \ I2 rium integration strategy when b 1. (ii.a) p1 p1 if and only if b r . Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition 30 Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society

BI2 \ NI2 I1I2 NI2 (ii.b) p1 p1 ;p2 p2 for I1 6¼ B. When forward integration gives manufacturer 1 the bF \ bF The threshold rI2 is stated in the proof in online Appen- pricing advantage ( 1 2), its product quality and dix E and the inequalities in (i.b) and (ii.b) hold strictly sales quantity always increase while those of the competitor decrease as shown in part (i). What happens when I1 6¼ N. when the competitor forward integrates is more sub- When facing a competing supply chain that is tle. When manufacturer 2 forward integrates, the already forward integrated, Proposition 8(i.a) shows competing supply chain 1 relying on its pricing that the quality of product 1 gets lower when manufac- advantage can respond aggressively by increasing its turer 1 backward integrates, whereas in the base model quality and force supply chain 2 to lower its quality. we find that vertical integration always increases prod- Part (ii) shows that when quality cost c is sufficiently uct quality. This is because the competing supply chain low, supply chain 1 indeed follows this hostile strat- relies on its pricing advantage, reacting to manufac- egy. However, when quality cost c is sufficiently high, turer 1’s backward integration by increasing quality of it cannot afford overinvesting in quality. In this case, its product. Consequently, manufacturer 1’s return supply chain 1 accommodates manufacturer 2’s for- from quality improvement gets lower, forcing it to ward integration by reducing its quality and quantity, lower its product quality. Additionally, contrary to our allowing manufacturer 2 to take advantage of forward earlier result where vertical integration always lowers integration to have higher quality and sales quantity. retail price, case (ii.a) shows that forward integration Finally, part (iii) demonstrates that the competitor is can increase the retail price when the pricing advan- more likely to respond aggressively to manufacturer tage is significant, because consumers become very 2’s forward integration when the competitor has a price insensitive. Thus, Proposition 8(i.b) and (ii.a) bigger pricing advantage. suggests that forward integration can increase both product quality and retail price when it has a signifi- 5.2. Dynamic Wholesale Pricing cant pricing advantage, that is, bF \ rI2 . In the base model, manufacturers set the same wholesale price for both periods. In this section, we examine 5.1.2. Asymmetric Price Sensitivity. In the previ- what happens if manufacturers can choose their ous section, the manufacturers have identical price wholesale prices dynamically in each period. sensitivity when they forward integrate, that is, Assumptions A1 and A2 described in section 3 are F F 9ð2þkÞ 5c b1 ¼ b2. Now, we relax this assumption, allowing for [ 1þk 9 replaced by m dð 2 6c Þ and 9 ð45 kÞþ bF 6¼ bF bF \ bF 1 2. Suppose 1 2 1 without loss of 1 [ 1 respectively in this extension. generality. 9k The next proposition shows that our key results Similar to section 5.1.1, we assume the price sen- continue to hold. Recall that II denotes manufactur- sitivity advantage is not extreme, specifically 1 2 ers’ equilibrium strategy. ð þ ÞbF ð ÞbF 1 3k 2 1 k 1 \ F F 54ck, to avoid the trivial cases. b1 b2 F PROPOSITION 10. Suppose manufacturers set wholesale Note that when b2 ¼ 1, this assumption becomes identical to that of section 5.1.1. The resulting equi- prices dynamically for each period and manufacturers choose librium quality, price, and sales quantity for each among no (N), forward (F), and backward (B) integration. scenario are summarized in Appendix C. Here, we (i) The equilibrium integration strategy is focus on results concerning competition between ( pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi two forward integrated manufacturers with asym- 8ð18c1Þþ12 cð18c1Þþ FF for k 1 ; metric price sensitivities, which is the most interest- I1 I2 ¼ 63c4 BB otherwise: ing scenario. (ii) Manufacturers encounter a prisoner’s dilemma, that PROPOSITION 9. II p 1 2 \ pNN NF \ FF NF \ FF NF [ FF is, i i . (i) Q1 Q1 , h1 h1 ,Q2 Q2 , and hNF [ hFF 2 2 . Proposition 10 shows that the key results of the nh nQ = (ii) There exists i and i ,i 1,2, such that base model continue to hold. That is, staying disinte- FN \ FF \ Q grated is never an equilibrium outcome when manu- ðaÞ Q1 Q1 if and only if c n1 , and FN \ FF \ h facturers consider both forward and backward h1 h1 if and only if c n1. ðbÞ QFN [ QFF if and only if c \ nQ, and integrations. Manufacturers prefer forward integra- 2 2 2 tion when the product is highly perishable and back- hFN [ hFF if and only if c \ nh. 2 2 2 ward integration when the return from quality h Q (iii) ni and ni are stated explicitly in the proof of the investment is low (the threshold in part (i) decreases F F proposition and they increase in b2 b1. in c). Furthermore, the equilibrium results in a Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society 31 prisoner’s dilemma. In the next corollary, we examine with g ¼ 4ðb=aÞ6 þ 324ðb=aÞ4c 45927ðb=aÞ2c2 þ how manufacturers’ dynamic pricing ability affects 59049c2ð18c 1Þ. their integration choices. (ii) Manufacturers encounter a prisoner’s dilemma, that I1 I2 NN is, pi pi . COROLLARY 2. Manufacturers are more likely to backward integrate when they gain dynamic pricing ability. No integration still cannot be an equilibrium outcome when manufacturers consider both forward and When manufacturers cannot set their wholesale backward integrations. Furthermore, the equilibrium prices dynamically, forward integration has the results in a prisoner’s dilemma. Moreover, the same as added benefit of enabling pricing flexibility. But when in our base model (see Proposition 2), the threshold in they already have the dynamic pricing ability, this part (i) increases in a and decreases in c and d. There- benefit is not as valuable, making forward integration fore our corresponding insights continue to hold. less attractive. Finally, the threshold in part (i) increases in the consumer sensitivity to retailer quality b, indicating that 5.3. Retailers’ Quality Contribution the manufacturers prefer forward integration when In the base model, product quality is determined the retail quality has a significant impact on the over- solely by the supplier. In some settings, retailers can all perceived product quality. Intuitively, when b is also affect the perceived product quality significantly, high, the retailer chooses a high level of quality for example, by their store design and employee train- investment. Because of the resulting high quality ing. We now consider what happens if retailers can product, the retailer tends to sell to a smaller segment, also contribute to the product quality. Thus, the con- which in turn forces the manufacturers to drop their sumer utility in Equation (1) is appended as follows price to maintain its sales quantity. Forward integra- with an additional term bhir, which is controlled by tion eliminates this problem for the manufacturer. the retailer. 5.4. Asymmetric Quality Cost : Ui;t ¼ m þ ahi þ bhir pi;t dwi ð12Þ Here we consider what happens when the two supply chains differ in their efficiency of quality improve- Here, hir is the quality level chosen by the retailer in ment. Specifically, ci shows the quality improvement supply chain i, and b 0 shows the consumer sensi- cost coefficient of supply chain i. Suppose c1 [ c2 tivity to retailer quality. To avoid introducing any without loss of generality. Let c1 ¼ c and c2 ¼ vc1, bias, we assume the supplier and the retailer have where v ∈ (0,1). Assumptions A1 and A2 are equal quality cost coefficients. Specifically, the retailer [ 1458c2ð5þ4kÞv9cð19þ17kÞð1þvÞþ4ð1þkÞ 2 replaced with m dð 12cð81cvð1þvÞÞ Þ incurs quality cost chir. Similar to our base model, 9vc 1 [ 1v quality decisions are made before pricing decisions, and 3þv ð11 kÞ 1 þ kð3þvÞ, respectively, which and suppliers precede manufacturers and retailers. reduce back to A1 and A2 when v = 1. Furthermore, Specifically, a supplier’s quality decision is followed we assume that the cost advantage is not extremely by that of the retailer, which is followed by the pricing high, that is, v [ 1þ3k , so that the high cost supply decisions. 1 kþ54ck chain can also sell its product in both periods. Assumptions A1 and A2 of the base model are = 2 = 2 replaced with m [ dððb aÞ ð2ðb aÞ ð1 þ kÞ81cð19 þ 17kÞÞ þ 54cð729c2ðb=aÞ2Þ PROPOSITION 12. Suppose suppliers have asymmetric ∈ 243ð9cð5þ4kÞð1þkÞÞ 9c 1 [ b 2 1 1 quality costs such that c2 ¼ vc1,v (0,1) and manu- 2 Þ and ð11 Þ 1 ðÞ ð ð 23Þþ 2ð729c2ðb=aÞ Þ 4 k a 72 k facturers choose among no (N), forward (F), and back- 1 b 2 972c ðaÞ Þ, respectively. Note these assumptions and ward (B) integration. our results in this section reduce to those of the base (i) NN cannot be an equilibrium. model when b = 0. The following proposition shows (ii) II ¼ NB for v d and k minðd ; d Þ. that our key results continue to hold when retailers 1 2 4 6 7 (iii) II ¼ FB for d \ k \ minðd ; d Þ, d to d are contribute to quality. 1 2 5 6 7 4 7 stated in the addendum in Appendix D.

PROPOSITION 11. Suppose both supplier and retailer con- Proposition 12 shows even with asymmetric costs, trol quality as in Equation (12) and manufacturers choose both firms staying disintegrated cannot be an equilib- among no (N), forward (F), and backward (B) integration. rium. While Proposition 12 does not state all possible (i) equilibrium outcomes (which are stated in Appendix ( pffiffiffiffiffiffi 2gþ þ18ð81c2ðb=aÞ2Þ cgþ D), it demonstrates the asymmetry in the quality costs ; FF if k1 = 6 = 2 2 2 I1I2 ¼ 4ðb aÞ 19683ðb aÞ c þ59049c ð9c1Þ can lead to asymmetry in equilibrium outcomes. Part BB otherwise ; (ii) illustrates that manufacturer 1 can stay disintegrated Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition 32 Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society while manufacturer 2 integrates backward when Basically, with pricing advantage a forward-inte- manufacturer 2 has a sufficiently strong cost advan- grated manufacturer undermines the return from tage. In this case, manufacturer 1 does not want to quality investment for its competitor, disallowing the increase the intensity of competition due to the com- competitor to take advantage of backward integra- petitor’s cost advantage. Finally, part (iii) shows that tion. While we provide several examples that show with the cost asymmetry, manufacturers can choose that forward integration may enable manufacturers to to integrate in the opposite directions in contrast to set higher prices in their company stores, there could our symmetric base model. be opposite examples whereby forward integration may increase the consumer price sensitivity. In those 6. Concluding Remarks examples, we expect forward integration to be less attractive for manufacturers and it would be less In this study we examine equilibrium vertical integra- likely to be an equilibrium outcome. tion strategies under supply chain competition. To While manufacturers with symmetric costs never this end, we analyze two competing three-tier supply stay disintegrated in equilibrium, the manufacturer chains, each with a supplier, a manufacturer, and a with the cost disadvantage can stay disintegrated retailer. Each manufacturer considers three vertical when there is cost asymmetry in our model. Further- integration strategies: forward, backward, and no more, organizational, cultural, and geographic barri- integration. Forward integration enables a manufac- ers, which are omitted in our model, can also stop turer to better manage the demand side by directly manufacturers from pursuing vertical integration. controlling the retail price, whereas backward inte- These factors are also omitted in McGuire and Staelin gration allows it to better manage the supply side by (1983), Gupta and Loulou (1998), and Trivedi (1998), directly controlling the quality investment. and they argue that firms choose to stay disintegrated When competing manufacturers consider solely mov- to avoid intensifying competition. Our results show ing from disintegration to forward integration, a cele- that competition alone cannot explain why firms may brated result in prior studies is that manufacturers may choose to stay disintegrated when backward integra- strategically choose to stay disintegrated (e.g., Gupta tion is an option in addition to forward integration. and Loulou 1998, McGuire and Staelin 1983). Interest- Our model has limitations. We assume that each ingly, we demonstrate this result does not continue to retailer sells a single product variant. However, in hold when backward integration is also an option for practice most retailers will be selling a product line; manufacturers. When they have both forward and back- thus we expect product proliferation to increase the ward integration options, both manufacturers choose to intensity of price competition. Because forward inte- vertically integrate (either forward or backward) even gration intensifies retail price competition more than though this results in a prisoner’s dilemma situation. backward integration, we expect forward integration We explain how the direction of vertical integration to be less valuable than our model predicts. Further- manufacturers choose in equilibrium depends on more, while each manufacturer has a single distinct supply and demand elements. Specifically, when the supplier in our model, they may have multiple sup- dynamics of demand perishability dominate, forward pliers and share some of these suppliers with their integration becomes more attractive. In contrast when competitors. In that case, there will be an additional the dynamics of product quality dominate, backward incentive for backward integration due to the added integration is preferred. Our equilibrium results char- benefit of controlling the competitor’s supply. This acterize this trade-off explicitly. can be a fruitful direction for future research. More We also quantify the value of unilaterally imple- broadly, it would be worthwhile to study how the menting vertical integration and how this relates to value of vertical integration depends on various sup- the structure of the competing supply chain. A verti- ply chain configurations. cally integrated competitor compared with a disinte- Forward and backward integration may have addi- grated competitor improves attractiveness of forward tional benefits beyond what is captured in our model. integration relative to backward integration. In addi- For example, forward integration may enable a manu- tion, backward integration always increases profit- facturer to collect more information about customer ability regardless of the structure of the competing demand. Moreover, in our model, upstream firms supply chain. In contrast, forward integration can be move before downstream firms and make a take-it-or- detrimental both when the competitor is vertically leave-it offer. This is a common assumption in papers integrated and when it is disintegrated. studying vertical integration decisions (Gray et al. Examples from practice suggest that forward inte- 2009, Liu and Tyagi 2011, McGuire and Staelin 1983, gration can reduce the consumer price sensitivity. Pun and Heese 2010). However, it would be worth- In this case, forward integration can make back- while for future research to study how vertical inte- ward integration unattractive for the competitor. gration choices depend on the relative bargaining Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society 33 power of the retailer and supplier within the supply ð1 þ kÞa h ¼ h ¼ ; p ; ¼ p ; ¼ dð7 þ 6kÞ; chain using a bargaining framework. Finally, our 1 2 6c 1 1 2 1 analysis is restricted to competition between two sup- 1 þ k p ; ¼ p ; ¼ dð6 þ 7kÞ; Q ¼ Q ¼ : ply chains, and an obvious extension would examine 1 2 2 2 1 2 2 the competition between many supply chains. (ii) When only manufacturer 1 forward integrates, FN: Because retail competition would be fiercer due to more competitors, we expect increasing the number ; ; dð1kÞ ; h1 ¼ð63c 2ÞA p1;1 ¼ B1 p1;2 ¼ B1 b of competitors to deteriorate attractiveness of forward 1 Q ¼ð63c 2ÞC; integration relative to backward integration. 1 ; ; ; h2 ¼ð45c 2ÞA p2;1 ¼ B2 p2;2 ¼ B2 dð1 kÞ Acknowledgments : Q2 ¼ð45c 2ÞC The authors thank the senior editor and the referees for (iii) When only manufacturer 1 backward integrates, BN: many helpful comments and suggestions. ; ; ; h1 ¼ð63c 2ÞD p1;1 ¼ E1 p1;2 ¼ E1 dð1 kÞ ; Appendix A: Monopoly Benchmark Q1 ¼ð63c 2ÞF The unique SPNE product quality h, retail price pt, = t 1,2, and sales quantity Q for a monopolist supply h2 ¼ð45c 2ÞD; p2;1 ¼ E1 þ E2; chain are as follows assuming it does not serve the p2;2 ¼ E1 þ E2 dð1 kÞ; Q2 ¼ð45c 2ÞF: entire market in both periods. (iv) When both manufacturers vertically integrate, FF, (i) When the manufacturer does not vertically BF, FB or BB: integrate: dð1kÞ h1 ¼ð27cb 2ÞG; p1;1 ¼ H1; p1;2 ¼ H1 ; 2 b1 ma ; 7cdm ; 2cm b cb h ¼ 8cda2 p1 ¼ p2 ¼ 8cda2 Q ¼ 8cda2. Q1 ¼ 1ð27 2 2ÞJ ; ; dð1kÞ ; h2 ¼ð27cb 2ÞG p2;1 ¼ H2 p2;2 ¼ H2 (ii) When the manufacturer forward or backward 1 b2 integrates: Q2 ¼ b2ð27cb1 2ÞJ ma ; 3cdm ; 2cm where h ¼ 4cda2 p1 ¼ p2 ¼ 4cda2 Q ¼ 4cda2. cd c ¼ ; In equilibrium, the monopolist manufacturer a2 c \ 1 chooses to forward integrate when 2 and it ð1 þ kÞa chooses to backward integrate otherwise. A ¼ ; 6cðð54c 1Þb1 1Þ dðk 1 15b 13kb þ cb ð495 þ 387kÞÞ Appendix B: Exogenous Quality B ¼ 1 1 1 ; 1 b c b Benchmark 2 1ðð54 1Þ 1 1Þ Let h be the quality level for both products, which is dðð504c 1Þb1 21 þ kð396cb1 þ b1 19Þ21Þ B2 ¼ ; exogenously determined. When the quality is deter- 2ðð54c 1Þb1 1Þ mined exogenously, assumption A1 is replaced by ð1 þ kÞ ; [ 3dð5þ4kÞ C ¼ m 2 ah, which helps avoid the trivial case 2ð54c 1Þb1 2 where firms form local monopolies in the NN scenario. ð1 þ kÞa D ¼ ; 12cð27c 1Þ PROPOSITION 13. When quality is exogenously deter- dð495c þ 3kð129c 4Þ16Þ mined, manufacturers always backward integrate when E ¼ ; 1 4ð27c 1Þ they choose among no (N), forward (F), and backward 3dð1 þ kÞð3c 2Þ (B) integration. E ¼ ; 2 4ð27c 1Þ ð1 þ kÞ Appendix C: Forward Integration F ¼ ; 4ð27c 1Þ Decreasing Price Sensitivity að1 þ kÞ G ¼ ; F \ = 6cð27cb1b2 b1 b2Þ LEMMA 4. Suppose bi 1,i 1,2; the unique SPNE dðb b cð135 þ 81kÞð9 þ 7kÞb þðk 1Þb Þ product quality hi, retail price pi;t, and sales quantity Qi H ¼ 1 2 i 3 i ; ; ; i b ð cb b b b Þ for each scenario I1I2,Ii 2fN F Bg, are as follows. 2 i 27 1 2 1 2 ð1 þ kÞ (i) When none of the manufacturers vertically inte- J ¼ ð cb b b b Þ grates, NN: 2 27 1 2 1 2 Lin, Parlakturk,€ and Swaminathan: Vertical Integration under Competition 34 Production and Operations Management 23(1), pp. 19–35, © 2013 Production and Operations Management Society and 5Recall that assumption A1 in our duopoly model assumes that two firms cover the market so they compete with 1 if Ii ¼ B ; each other rather than forming local monopolies. How- bi ¼ F\ bi 1 if Ii ¼ F ever, vertical integration can help a manufacturer increase its demand in both periods, as one firm does not cover the entire market by itself since assumption A2 ensures Appendix D. Addendum to that the other firm has a positive market share. 6In line with this finding, when quality investment cost Proposition 12 disappears, that is, quality is exogenously fixed, backward (iv) I1I2 ¼ FF for k d5. integration is always preferred, as seen in Appendix B. [ ; 7 (v) I1 I2 ¼ BB for v d4 and k minðd6 d7Þ. As a robustness check, we have verified that this finding continues to hold when total market size is independent d4 is the largest root of v such that of k, specifically when period 1 and 2 market sizes are < 2 2 1 k and k, respectively, with k 1/2. ð27c 1Þð1 þ v 54cvÞ ð27cv 2Þ 8Note that both FF and NN can be equilibria for \ þ 27cð45cv 2Þ2ð1 þ v 27cvÞ2 ¼ 0 d1 k d2 but only NN survives because it is Pareto dominant in the sense that both manufacturers achieve a higher payoff with NN. d5 is the smaller root of k such that 9To make the model exactly identical to a single-period Â ^ 6561ð1 þ 6k þ k2Þc3v2 243c2vð1 þ 6v þ 10kð1 þ 2vÞ model, quality cost needs to be scaled to c ¼ 2c and profits need to be divided by 2 to account for the fact that þ k2ð1 þ 6vÞÞ þ 9cð10v 1 þ 7v2 þ k2ð10v 1 þ 7v2Þ Ã quality investment is recovered over two periods instead þ 2kð1 þ 14v þ 9v2ÞÞ 4ð1 þ kÞ2v ¼ 0 of one. 10The prices were collected on February 11, 2010, from both physical and online stores. d6 is the smaller root of k such that Â 4ð1 þ kÞ2 6561ð1 þ 6k þ k2Þc3v2 þ 243c2vð1 þ 6v References þ 10kð1 þ 2vÞþk2ð1 þ 6vÞÞ þ 9cðv2 k2ð7 þ 10v v2Þ AT&T. 2012. 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