Product differentiation and vertical integration in presence of double marginalization

In this paper, we present a model of endogenous vertical integration and horizontal differentiation. There exists two output brands and two versions of the input. The only mean for output differentiation is the input version used in output production. Firms may choose to vertically integrate to produce internally the required input version at marginal cost, rather then to buy it at the market price, if that version is made available. We show that vertical mergers increase the possibility that output goods are differentiated. Moreover, this occurs when the cost to differentiate the input is high. On the other hand, vertical integration is detrimental for brand variety if the cost to differentiate inputs is negligible.