Mutual Outsourcing in an Equilibrium Vertical Structure

ABSTRACT We examine the endogenous choice of vertical structure under Bertrand and Cournot competition in the presence of mutual outsourcing between downstream firms. Each downstream firm requires two essential inputs: one unit supplied by its exclusive upstream firm and one unit purchased from its downstream rival. Under Bertrand competition, vertical integration emerges as the unique equilibrium, even though vertical separation yields higher consumer surplus and social welfare. Conversely, under Cournot competition, vertical separation emerges in equilibrium, whereas vertical integration would enhance welfare. These results are driven by a mutual input price effect: upstream suppliers charge input prices below the marginal production cost under Bertrand competition but above it under Cournot competition. Our findings show that mutual outsourcing fundamentally alters upstream pricing incentives.