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On the timing of vertical relationships

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Author Info

  • Etienne Billette de Villemeur

    () (Toulouse School of Economics, IDEI & GREMAQ, 21 allée de Brienne, 31000 Toulouse, France)

  • Richard Ruble

    () (EMLYON Business School, Ecully, F-69134, France)

  • Bruno Versaevel

    () (EMLYON Business School & CNRS, GATE, 69134 Ecully cedex France)

Abstract

In a real option model, we show that the standard analysis of vertical relationships transposes directly to investment timing. 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 incertain 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, and we show how market growth rate and volatility affect the extent of the distortion. If the initial market demand is high, greater volatility increases the effective investment cost and results in lower value for both firms. Vertical restraints can restore efficiency. For instance, the upstream firm can induce entry at the correct investment threshold by selling a call option on the input. Otherwise, if two downstream firms are engaged in a preemption race, the upstream firm sells the input to the first investor at a discount which is chosen in such a way that the race to preempt exactly offsets the vertical distortion, and this leader invests at the optimal time.

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Bibliographic Info

Paper provided by Groupe d'Analyse et de Théorie Economique (GATE), Centre national de la recherche scientifique (CNRS), Université Lyon 2, Ecole Normale Supérieure in its series Working Papers with number 1118.

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Date of creation: 2011
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Handle: RePEc:gat:wpaper:1118

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Keywords: investment timing – preemption – real options – vertical relations;

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