Randal Heeb Innovation and Vertical Integration in Complementary Markets

This paper studies vertical integration by an essential-good monopolist into complementary markets. Unlike previous studies of complementary products, consumers are allowed to purchase some components of a complementary basket, but not others. Two different pricing strategies by the integrated firm may emerge. In mass-market equilibria, the price of the complement under integration is zero and it is given away with the essential good. Niche-market equilibria have more conventional pricing. This dichotomy is consistent with consumer software pricing. Integration enhances consumer and total surplus, unless it leads to exit by the higher-quality rival, in which case welfare is reduced. Exit is most likely when it is least damaging to consumer welfare. Integration reduces innovation by the rival firm. The effect on innovation by the integrated firm is ambiguous, but numerical computation of an extended model indicates that integration increases the innovation of the integrated firm and enhances welfare.