WORKING PAPER Product Competition and Upstream Flexible Specialization

This paper examines the relationship between a differentiated downstream market and a specialized upstream market. We analyze four different ways price competition takes place 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. The key factor affecting prices and the relative profitability of the different market organizations is the degree of product differentiation among the downstream firms. This factor is important not only because it affects profitability downstream, but also because it affects indirectly the intensity of competition among upstream suppliers. We also show that vertical foreclosure by the partially integrated firms is not an equilibrium strategy. JEL CLASSIFICATION: D40, L22.