Incentives and coordination in vertically related industries

This paper is motivated by the issue of how a firm's configuration and incentive structures encourage strategic business units to improve profit in oligopolistic value chains. To study this question I propose an evolutionary agent-based model incorporating key aspects of the functioning of the gas and electricity wholesale industries in the short-run. Gas is a crucial input to generate electricity. Generators buy wholesale gas and sell electricity to retailers that, in turn, compete for customers.

In this setting, there is one firm with one gas producing and one electricity generation units. I show that formal trading internalisation but also reward interdependences between the two business units alleviate hold-up problems. I also show that these two instruments are substitutes to enhance market power in vertically related industries: the integrated firm manages to increase gas prices and, thus, costs for rival electricity generators. The threshold of reward interdependence from which the results emerge is surprisingly low. Reward interdependence yields an aligning of interests that is equivalent to trading internalisation, without requiring any other means of formal coordination. Finally, I check for alternative explanations for the results and discuss the principal implications of my findings.