Option contracts in a vertical industry

We examine, in a vertical industry, the strategic role of horizontal subcontracting through option contracts by a downstream dominant firm competing with a competitive fringe. Downstream production requires an input from an upstream component-producing industry composed of imperfectly competitive suppliers. We characterize how the dominant firm may outsource downstream production from fringe firms in order to gain bargaining clout in the upstream input market. It is shown that option contracts are preferred to fixed-quantity forward contracts, because leverage against upstream suppliers is gained at lower contract prices. When there is no market uncertainty option contracts do not alter spot prices beyond that caused by unavoidable market power, whereas they increase price volatility whenever demand is subject to uncertainty