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Integration versus non-integration: specific investments and ex-post resource distribution

I adopt a non-cooperative game theoretic approach to an incomplete contracting transaction model, à la Grossman & Hart (1986), Hart & Moore (1990) and Bolton & Whinston (1993), consisting of one upstream firm and two downstream firms. When the downstream firms need to make relation-specific investments, they can increase their ex-post bargaining position by vertically integrating ex-ante with the upstream firm with an essential asset. By introducing an explicit mechanism, bidding, which the firms can use to transfer the control right of the upstream asset, I compare the regimes of vertical integration (ex-ante) with ex-post renegotiation and non-integration, analyse equilibrium investment incentives, and show that vertical integration will evolve under certain conditions.