BUYER-SUPPLIER INTERACTION, ASSET SPECIFICITY, AND PRODUCT CHOICE

Abstract

The goal of this paper is to explore how the demand for specific investments may affect the product variety in a bilateral duopolistic industry. In the literature on the hold-up problem, it is generally assumed that the degree of specificity of investments is either exogenously determined or chosen by the suppliers. We develop a model where the degree of specificity of investments is endogenously determined through the product choices of both buyers and suppliers. In an environment where input prices are determined by bilateral negotiations, we show that the existence of alternative buyers causes suppliers to choose less-than-fullyspecialized input types. Their location and investment choices crucially depend on the degree of product differentiation in the downstream market. This implies that the buyers may choose to increase their own competition by producing more similar products in order to increase the suppliers’ investment incentives. The results offer an explanation for why we may observe instances of intermediate product differentiation by focusing on the interactions between buyers and suppliers.asset specificity, vertical interactions, product differentiation