WORKING PAPER Product Differentiation and Upstream-Downstream Relations

This paper examines the relationship between a differentiated downstream market and a specialized upstream market. We analyze four different types of vertical relation between the upstream and downstream sectors when the upstream market supplies specialized and complementary inputs to a downstream product differentiated market. The first is the benchmark case of decentralized markets, the second is a network of alliances among upstream suppliers, the third is partial vertical integration and the fourth is an upstream consortium of suppliers. We identify the perfect equilibrium for a symmetric model in each case and show that there is no simple relationship between the degree of connection between upstream and downstream firms and profitability. The key factor affecting prices and the relative profitability of the different market organizations is the degree of product differentiation among the downstream firms because it affects the intensity of competition among upstream suppliers. We show that vertical foreclosure by the partially integrated firms is not an equilibrium strategy. JEL CLASSIFICATION: D40, L22.