Let Your Rival Own a Stake in Your Manufacturer: An Incentive Mechanism for Upward Decentralization

Abstract

We explore firms' incentives for upward channel decentralization through the strategic acquisition of minority passive ownership stakes in a competitor's manufacturer, a mechanism termed diagonal passive ownership (DPO). Using the classical Hotelling model with two competing retailers, we illustrate how DPO allows retailers to indirectly gain a share in each other's strong markets through inputs. This mechanism incentivizes upward decentralization by introducing an asymmetric effect: while both downstream and upstream competition are reduced, the softening effect is more pronounced downstream. As a result, retailers' profits increase without adversely affecting manufacturers, resulting in an overall increase in total industry profit. We further demonstrate that bilateral decentralization with DPO emerges as a Pareto-improving equilibrium-compared to no decentralizationwhen the ownership stake is sufficiently large to ensure a strong asymmetric effect in softening competition. However, to maximize benefits, the ownership stake does not need to be maximized; rather, it should be set at a level where downstream competition is just preserved. Furthermore, for the mechanism to be effective, the efficiency gap between retailers should be neither too small nor too large. For academics, our research introduces a novel financial-ownership-based incentive for production outsourcing. For managers, our findings suggest that outsourcing production while acquiring passive ownership in each other's manufacturers can lead to a win-win outcome. For policymakers, we propose how this practice can be used as a strategic tool to dampen competition.