Do Downstream Firms Strategically Accept Upstream Equity Participation?

This paper examines downstream firms’ incentives to accept equity participation by an upstream supplier in a vertically related market. We develop a multi-stage model in which the upstream firm offers an equity stake and sets input prices under price discrimination, while downstream firms subsequently compete à la Cournot. We show that upstream equity ownership induces the upstream firm to lower input prices by partially internalizing downstream profits. This mechanism generates a positive market-expansion effect for downstream firms through lower input costs, while equity ownership simultaneously creates a negative equity-dilution effect by reducing the share of profits retained by downstream firms. When products are homogeneous, the equity-dilution effect dominates the market-expansion effect, leading downstream firms into a Prisoner’s Dilemma. In contrast, under product differentiation, when the ownership share is sufficiently small, the market-expansion effect dominates the equity-dilution effect, resulting in higher downstream profits. In this case, accepting equity participation can be individually optimal for downstream firms, even though mutual acceptance may reduce their retained profits.