The objective of this paper is to endogenously determine the downstream firms’ mode of competition, in the context of a two-tier industry, as well as to investigate whether and how vertical relations can act as a commitment device to a particular mode of competition.
To fulfill this objective, we consider an environment with two upstream and two downstream firms that are locked in exclusive relations.1 The timing of moves is as follows. At stage one, each upstream-downstream pair, simultaneously and independently from the rival pair, determines its downstream firm’s specific input price and the mode of competition that the firm will materialize at the second stage.
This specific input price/mode of competition scheme is the result of an implicit agreement within each pair obtained as follows: For any ex-ante presumed pair- specific input price/mode of competition configuration in the industry, the downstream firm proposes a unilateral ex-post deviation to an alternative mode of competition, and its input supplier, if agrees, dictates the downstream firm’s specific input price corresponding to that deviation. Otherwise, e.g., if the supplier disagrees, the two agents stick to the originally presumed configuration. In the latter instance, the input supplier effectively acts as the downstream firm’s commitment devise to the presumed mode of competition, deterring the firm from unilaterally shifting ex-post to a different mode. At stage two, downstream firms compete in the product market on the ─ chosen as above ─ types of contracts to be offered consumers.