Working Paper: CEPR ID: DP6104
Authors: Rocco Macchiavello
Abstract: Does vertical integration reduce or increase transaction costs with external investors? This paper analyzes an incomplete contracts model of vertical integration in which a seller and a buyer with no cash need to finance investments for production. The firm is modeled as a "nexus of contracts" across the intermediate input supply and the financing transaction. The costs and benefits of vertical integration depend on the relative importance of a positive "contractual centralization" effect against a negative "de-monitoring" effect: the firm centrally organizes the nexus of contracts reducing the extent of contractual externalities while the market disciplines decisions driven by private benefits. Larger projects, more specific assets, and low investors protection are determinants of vertical integration.
Keywords: contractual externalities; investors protection; limited liability; theory of the firm; vertical integration
JEL Codes: D23; G32; K12; L22; O10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Vertical Integration (L22) | Reduction in Transaction Costs (D23) |
| Positive Contractual Centralization Effect (D86) | Reduction in Transaction Costs (D23) |
| Vertical Integration (L22) | Positive Contractual Centralization Effect (D86) |
| Vertical Integration (L22) | Negative Demonitoring Effect (E71) |
| Negative Demonitoring Effect (E71) | Increase in Opportunistic Behavior by Management (G34) |
| Degree of Asset Specificity (G31) | Favor Vertical Integration (L22) |
| Size of Projects (C55) | Favor Vertical Integration (L22) |
| Level of Investor Protection (G18) | Likelihood of Integration (F15) |