Vertical Firm Boundaries: Supplier-Customer Contracts and Vertical Integration
University of Arizona - Department of Finance
March 15, 2011
I empirically examine the choice of a firm’s vertical boundaries — specifically, the decision to use supplier-customer contracts instead of either using markets or vertical integration. I examine the determinants of supplier-customer contracts using data on a customer’s contractual purchase obligations with its suppliers. Contracting propensity is positively related to supplier relationship-specific investments (RSI), the supplier’s relative bargaining power, and vertical integration costs, and negatively related to contracting costs, alternative sources of information about the customer, and the percentage of a customer’s input traded on financial markets. Additionally, I examine the choice between vertical integration versus supplier-customer contracts and find that the choice is predicted by the type of RSI. Consistent with theory, RSI measured using tangible (intangible) assets are positively related to integration (contracts). Further, industry-wide RSI shocks are related to subsequent changes in a firm’s contracting and integration activity. My results suggest that market frictions play an important role in shaping supplier-customer contracting activity and firm boundaries.
Number of Pages in PDF File: 53
Keywords: Product markets, corporate finance, vertical integration, contracting, relationship-specific investment
JEL Classification: G30, G34, L14, L22
Date posted: March 19, 2011 ; Last revised: April 3, 2012