DP6104 Financial Constraints and the Costs and Benefits of Vertical Integration

Author(s): Rocco Macchiavello

Publication Date: February 2007

Keyword(s): contractual externalities , investors protection , limited liability , theory of the firm , vertical integration

JEL(s): D23 , G32 , K12 , L22 , O10

Programme Areas: Development Economics , Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP6104.asp.asp

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.