DP7899 Trade Policy and Firm Boundaries

Author(s): Laura Alfaro, Paola Conconi, Harald Fadinger, Andrew Newman
Publication Date: June 2010
Keyword(s): Firm Organization, Regional Trade Agreements, Tariffs
JEL(s): D23, F13, F23
Programme Areas: Industrial Organization, International Trade and Regional Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=7899

We study how trade policy affects firms’ ownership structures. We embed an incom- plete contracts model of vertical integration choices into a standard perfectly-competitive international trade framework. Integration decisions are driven by a trade-off between the pecuniary benefits of coordinating production decisions and the managers’ private benefits of operating in preferred ways. The price of output is a crucial determinant of this choice, since it affects the size of the pecuniary benefits: higher prices lead to more integration. Because tariffs increase domestic product prices, this effect provides a novel theoretical channel through which trade policy can influence firm boundaries. We then examine the evidence, using a unique dataset to construct firm-level indexes of vertical integration for a large set of countries. In line with the predictions of our model, we obtain three main results. First, higher tariffs lead to higher levels of vertical integration. Second, differences in ownership structure across countries, measured by the difference in sectoral vertical integration indexes, are smaller in sectors with similar levels of protection. Finally, ownership structures are more alike among members of regional trade agreements.