Weathering a Demand Shock: The Impact of Prior Vertical Scope on Post-shock Firm Response

Abstract

We examine how and why pre-existing vertical scope may cause differences in
product market exit rates after sudden and exogenous decreases in demand. Our empirical context is the U.S. medical diagnostic imaging industry (2004-2009), wherein a major Medicare reform created a derived demand shock to equipment manufacturers. Using a difference-in-difference-in-difference design, we find integrated firms were more likely to exit than nonintegrated firms. Building on the literature conceptualizing firms’ pre-shock vertical scope as a representation of existing resources and governance choices, we explain that integrated and nonintegrated firms responded differently by leveraging their own distinctive capabilities. Our qualitative insights suggest that higher market exit of integrated firms was driven by their higher adjustment costs due to frictions across strategies for demand management vs. cost reduction.

Keywords: demand shock, vertical scope, market exit, medical diagnostic imaging, Medicare reform