DP9200 Do Prices Determine Vertical Integration? Evidence from Trade Policy

Author(s): Laura Alfaro, Paola Conconi, Harald Fadinger, Andrew Newman
Publication Date: October 2012
Date Revised: May 2013
Keyword(s): product prices, theory of the firm, vertical integration
JEL(s): D2, L2
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9200

What is the relationship between product prices and vertical integration? While the literature has focused on how integration affects prices, this paper shows that prices can affect integration. Many theories in organizational economics and industrial organization posit that integration, while costly, increases productivity. If true, it follows from firms' maximizing behavior that higher prices cause firms to choose more integration. The reason is that at low prices, increases in revenue resulting from enhanced productivity are too small to justify the cost, whereas at higher prices, the revenue benefits exceeds the cost. Trade policy provides a source of exogenous price variation to assess the validity of this prediction: higher tari ffs should lead to higher prices and therefore to more integration. . We construct firm-level indices of vertical integration for a large set of countries and industries and exploit cross-section and time-series variation in import tari s to examine their impact on firm boundaries. Our empirical results provide strong support for the view that output prices are a key determinant of vertical integration.