Do Prices Determine Vertical Integration?

7 June 2013 at 2:47 pm Dick Langlois Leave a comment

| Dick Langlois |

The title of this paper, by Laura Alfaro, Paola Conconi, Harald Fadinger, and Andrew F. Newman, caught my eye. Then the abstract really caught my attention.

What is the relationship between product prices and vertical integration? While the literature has focused on how integration affects prices, this paper shows that prices can affect integration. Many theories in organizational economics and industrial organization posit that integration, while costly, increases productivity. If true, it follows from firms’ maximizing behavior that higher prices cause firms to choose more integration. The reason is that at low prices, increases in revenue resulting from enhanced productivity are too small to justify the cost, whereas at higher prices, the revenue benefit exceeds the cost. Trade policy provides a source of exogenous price variation to assess the validity of this prediction: higher tariffs should lead to higher prices and therefore to more integration. We construct firm-level indices of vertical integration for a large set of countries and industries and exploit cross-section and time-series variation in import tariffs to examine their impact on firm boundaries. Our empirical results provide strong support for the view that output prices are a key determinant of vertical integration.

The surprising part is not the empirical result, which is interesting. The surprising part is that the underlying theory of vertical integration in the paper is no more sophisticated than what’s in the abstract: vertical integration is always more efficient than using the market, because a lot of people like Williamson and Hart and Moore have said so. Since integration implies fixed costs, firms (in perfect competition) won’t engage in this wonderful and indisputably efficient practice unless prices are high enough to cover the fixed costs. Readers of this blog will not need me to tell them what’s wrong with this. But I like the empirical result, which is consistent with my own suspicion that tariffs provide cover for firms to engage in inefficient vertical integration. The right spin on this result may well be the Michael Jensen story: lack of competitive pressure from the product market enables managers to retain earnings, which they spend on buying divisions or integrating into things they could buy more cheaply on the market.