Endogenous Spatial Differentiation with Vertical Contracting

Abstract

We set-up a linear city model with duopoly upstream and downstream. Consumers have a transportation cost when buying from a retailer, and retailers have a transportation cost when buying from a wholesaler. We characterize the equilibria in a five-stage game where location and pricing decisions (wholesale and retail) by all four firms are endogenous. The usual demand and price competition effects are modified and an additional strategic effect emerges, since the retailers' marginal costs become endogenous. Firms tend to locate farther away from the market center relative to the vertically integration case. When the wholesalers choose locations before the retailers, each wholesaler locates closer to the market center relative to the retailer locations, and relative to when the wholesalers cannot move first. Each wholesaler does this to strengthen the strategic position of its retailer by credibly pulling him towards the market center. As a result, the intensity of competition is higher and industry profit is lower when upstream locations are chosen before downstream locations. Variations of the model and welfare analysis are provided.

Keywords: Linear city, Locations, Spatial differentiation, Strategic commitment, Vertical contracting

JEL Classification: L13, R32