DP2280 Incomplete Contracts and Industrial Organization

Author(s): Gene Grossman , Elhanan Helpman

Publication Date: November 1999

Keyword(s): Hold-Up Problem , Input Specificity , Vertical Integration

JEL(s): D23 , D43 , D51

Programme Areas: Industrial Organization

Link to this Page: www.cepr.org/pubs/dps/DP2280.asp

We develop an equilibrium model of industrial structure in which the organization of firms is endogenous. Differentiated consumer products can be produced either by vertically integrated firms or by pairs of specialized companies. Production of each variety of consumer good requires a unique, specialized component. Vertically integrated firms can manufacture the components they need in the quantity and type that maximizes profits, but they face a relatively high cost of governance. Specialized firms can produce at lower cost, but input suppliers face a potential hold-up problem. We study the equilibrium mode of organization when inputs are fully or partially specialized. We consider how the degree of competition in the market and other parameters affect the equilibrium choices, and how the equilibrium compares with the efficient allocation.