DP9004 A Price Theory of Vertical and Lateral Integration (Revised Version)

Author(s): Patrick Legros, Andrew Newman
Publication Date: June 2012
Keyword(s): decision rights, incomplete contracting, industrial organization, integration, ownership
JEL(s): D2, D4, L1, L2
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9004

We present a perfectly-competitive model of firm boundary decisions and study their interplay with product demand, technology, and welfare. Integration is pri- vately costly but is effective at coordinating production decisions; non-integration is less costly, but coordinates relatively poorly. Output price influences the choice of ownership structure: integration increases with the price level. At the same time, own- ership affects output, since integration is more productive than non-integration. For a generic set of demand functions, the result is heterogeneity of ownership and perfor- mance among ex-ante identical enterprises. The price mechanism transmutes demand shifts into industry-wide re-organizations and generates external effects from techno- logical shocks: productivity changes in some firms may induce ownership changes in others. If the enterprise managers have full title to its revenues, market equilibrium ownership structures are second-best efficient. When managers have less than full revenue claims, equilibrium can be inefficient, with too little integration.