Technology of upstream firms and equilibrium product differentiation

Using a Hotelling-type product differentiation model (linear city model), we investigate the location strategies of upstream and downstream firms. We show that when transport costs of upstream firms are large, higher transport costs decrease the level of product differentiation of downstream firms. We also show that more inefficient transport technologies of upstream firms may enhance welfare. We briefly discuss vertical mergers and show that vertical mergers occur if the transport costs of upstream firms are large enough.