DP7211 A Price Theory of Vertical and Lateral Integration

Author(s): Patrick Legros, Andrew Newman
Publication Date: March 2009
Keyword(s): decision rights, incomplete contracts, integration, ownership, price theory
JEL(s): D21, D41, D86
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=7211

We construct a price-theoretic model of firms' integration decisions under perfect competition and study their interplay with consumer demand and welfare. Integration is costly to implement but is effective at coordinating production decisions. The price of output influences the ownership structure chosen: there is an inverted-U relation between the degree of integration and product price. Ownership in turn affects output: integration is more productive than non-integration at low prices, and less productive at high prices. If the managers deciding organizational design have full claim to firm revenues, market equilibrium ownership choices will be second-best efficient. When managers have less than a full claim on profits, however, total welfare may sometimes be increased by a social planner who could force some firms to reorganize. The price mechanism tends to correlate reorganizations across firms and generates external effects of technological shocks: productivity changes in some firms may have little effect on their own organization, while inducing changes of ownership in the rest of the industry. Terms of trade in supplier markets also affect ownership structure; entry of low-cost suppliers may induce reorganizations that raise prices. The model can generate coexistence of different ownership structures, even among ex-ante identical firms.