Vertical Integration by Competitive Firms: Uncertainty and Diversification

In this paper, we distinguish the circumstances under which uncertainty and risk aversion create incentives or disincentives for vertical integration by competitive firms in adjacent stages of an industry. The uncertainty is allowed to impinge upon the industry via the supply of a factor, the external demand for the intermediate product, or the demand for the final product. The decision on vertical integration is prior to the revelation of the uncertain parameters. However, firms choose production levels and all markets clear after these parameters are observed. Since the uncertain parameters influence the rents earned by the firms in the two stages, vertical integration can alter the distribution of these earnings. For each type of uncertainty we examine the conditions under which vertical integration will or will not result in diversification of the risks on rental earnings. Previous analyses of vertical integration by competitive firms under uncertainty have exhibited incentives to integrate which result from differential information or the inability of markets to clear. In Arrow [1], upstream firms possess some information about the total input supply while downstream firms possess no information. Since downstream firms must make ex ante choices of technology, there is an information incentive to integrate backward. In Green [3], the price in the intermediate market is fixed so that fluctuations in the external demand for the intermediate product result in rationing of either upstream or downstream firms. Balanced integration allows the combined firms to avoid rationing. Finally, in Carlton [2], some consumers are unable to obtain the final product while some downstream firms are burdened with an excess supply. Furthermore, some downstream firms which wish to produce more of the final product are unable to do so while some producers of the intermediate product are burdened by overproduction. As a result, there is an incentive for downstream firms to integrate into production of the intermediate product so as to insure a supply sufficient to produce that portion of their demand which is highly probable.