DP5903 Contractual Institutions, Financial Development and Vertical Integration: Theory and Evidence

Author(s): Rocco Macchiavello
Publication Date: October 2006
Keyword(s): contract enforcement, credit constraints, developing countries, industry equilibrium, vertical integration
JEL(s): D23, L11, L22, O14
Programme Areas: Development Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5903

This paper develops an industry equilibrium model of vertical integration under contractual imperfections with specific input suppliers and external investors. I assume that vertical integration economizes on the needs for contracts with specific input suppliers at the cost of higher financial requirements. I show that the two forms of contractual imperfections have different effects on the degree of vertical integration, and that contractual frictions with external investors affect vertical integration through two opposing channels: a direct negative, investment, effect and an indirect positive, entry, effect. Using cross-country-industry data, I present novel evidence on the institutional determinants of international differences in vertical integration which is consistent with the predictions of the theoretical model. In particular, I show that countries with more developed financial systems are relatively more vertically integrated in industries that are dominated by large firms.