Abstract
In a real options model, we show that the standard analysis of vertical relationships transposes directly to investment timing. Thus, when a firm undertaking a project requires an outside supplier (e.g., an equipment manufacturer) to provide it with a discrete input to serve a growing but uncertain demand, and if the supplier has market power, investment occurs too late from an industry standpoint. The distortion in rm decisions is characterized by a Lerner-type index, and we show how market growth rate and volatility a¤ect the extent of the distortion. If the initial market demand is high, greater volatility increases the e¤ective investment cost, and results in lower value for both rms. Vertical restraints can restore e¢ ciency. For instance, the upstream firm can induce entry at the correct investment threshold by selling a call option on the input. Otherwise, if two downstream firms are engaged in a preemption race, the upstream firm sells the input to the first investor at a discount which is chosen in such a way that the race to preempt exactly offsets the vertical distortion, and this leader invests at the optimal time.