Do Prices Determine Vertical Integration?

Abstract

What is the relationship between product prices and vertical integration? While the literature has focused on how integration affects prices, this paper provides evidence that prices can affect integration. Many theories in organizational economics and industrial organization posit that integration, while costly, increases productivity. It follows from firms' maximizing behavior that higher prices induce 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 high 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 firmlevel 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. JEL classifications: D2, L2, Keywords: Theory of the firm, vertical integration, product prices. * We are grateful to Daron Acemoglu, Robby Akerlof, Nick Bloom, Francesco Decarolis, Bob Gibbons, Davin Chor, Gene Grossman, Maria Guadalupe, Ali Hortaçsu, Louis Kaplow, Patrick Legros, Margaret McMillan, Emanuel Ornelas, Mike Powell, Raffaella Sadun, Chad Syverson, John Van Reenen, Chris Woodruff and numerous seminar and conference participants for their valuable suggestions and comments. Research funding from the FNRS and the European Commission (PEGGED collaborative project) is gratefully acknowledged by Conconi. For their hospitality and support, Newman is grateful to the Yale Economic Growth Center and the Brown Population Studies and Training Center. We thank Francisco Pino, Andrea Colombo and Qiang Wang for excellent research assistance.

Outsourcing of peripheral services: Evidence from Spanish manufacturing plant-level data

“…First, firm scale could be very well affecting the optimal organizational form of the firm and therefore changing outsourcing practices, holding fixed the nature of the contracting problem, as in our model, Alfaro et al (2013) or Grossman and Helpman (2002). Second, firm level factors could affect both firm scale and outsourcing and therefore generate spurious correlations, as in Egger and Egger (2004), Tomiura (2007), or Acemoglu et al (2010).…”

“…In a nutshell, our simple model (adapted from Alfaro et al, 2013) predicts that increases in prices, market share and competition will be positively correlated with increases in outsourcing of peripheral services. Because the model is flexible enough, we are able to introduce TCE and PRT extensions (detailed in the Appendix).…”

“…In this section, we adapt the theoretical framework in Alfaro et al (2013) to introduce a simple model of peripheral service outsourcing in manufacturing. Assume that a firm (factory or plant) needs to complete two tasks that we differentiate as core and peripheral.…”

“…Following Alfaro et al (2013), let us assume that a firm maximizes profits such that max Q ;t1;t2;DI PQ À Ψ ðt 1 ÞCðQ ÞÀΦðt 2 ÞD I ÀWðt 2 Þð1 À D I Þ subject to a managerial time constraint such as t 1 þ t 2 ¼ T In this setting, P is the price of the product in the market, Q is the quantity to produce, t 1 is the time dedicated to manage production such that the total cost of production C(Q) is scaled by a factor Ψ ðÁÞ where Ψ 0 o0. D I is a dummy variable that takes value 1 when the manager decides to integrate the peripheral service and 0 otherwise.…”

“…They use variation in contractibility across peripheral services to explain outsourcing patterns across manufacturing plants. Our paper differs from theirs in that we use a simple model based on Alfaro et al (2013) focusing on a strategic motive of outsourcing peripheral services to increase managerial effort on core activities. On the other hand, Knudsen and Foss (2014), using a TCE framework, find that outsourcing of non-core activities increased during the 2007 recession.…”