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

Publication Date

03/06/2012

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Abstract

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.