RESEARCH PAPER NO. 885

BUYER-SUPPLIER INTERACTION, ASSET SPECIFITY, AND PRODUCT CHOICE

BY

NISVAN ERKAL

NOVEMBER 2003

Department of Economics. University of Melbourne. Melbourne Victoria 3010 Australia

This paper analyses the links between investment decisions in multilateral contexts and firms' product choices in an environment where input prices are determined by bilateral negotiations. In the literature on the hold-up problem, it is generally assumed that the degree of specificity of investments is either determined exogenously or chosenby the suppliers. We develop a model where the degree of specificity of investments is endogenously determined through the product choices of both buyers and suppliers. Buyers care about both how much investment is made by suppliers in the development of an input and how suitable the input is for their own needs. We determine four forces thatmay affect the product choices of firms: the competition effect, the investment effect, thespecificity effect, and the bargaining effect. We show that when the suppliers have access to alternative buyers, they will choose to locate in between their intended buyer and the alternative buyer. Their specific location choices depend critically on their relative bargaining power. The buyers may choose to increase their own competition by producing more similar products in order to increase the value of the suppliers' outside options and, thus, their investment incentives. When the buyers have access to alternative input sources, they may choose to produce more similar products in order to improve the value of their outside options or to locate closer to the only supplier in the market. The results offer an explanation for why we may observe instances of intermediate product differentiation by focusing on the interactions between buyers and suppliers.