Transaction Costs and Capacity Costs as Interrelated Determinants of Vertical Integration in Oligopolies

This paper considers a two-stage oligopoly model with downstream retailers and two types of transaction costs (in contracting retailers and in direct retailing). Our analysis shows how transaction costs affect vertical integration in a strategic model of oligopoly, and it relates transaction costs to other characteristics of oligopolistic industries. In particular, we show that long- and short-term capacity costs interrelate in a rather complex manner with transaction costs in determining the degree of vertical integration. Our analysis thus challenges the focus of New Institutional Economics on transaction costs. In light of the results, we finally discuss welfare implications of regulatory interventions.