Investment Under Uncertainty: Do Firm Boundaries Matter?

Abstract

We examine how firms’ vertical structure affects investment under output price uncertainty. Exploiting a unique industrial organization in the oil exploration and production industry, where certain producers vertically integrate into downstream segments, we find that these integrated producers cut investments significantly more than do standalone producers under exogenous oil price uncertainty shocks. This finding is consistent with a real option model of investment, where a higher level of capital irreversibility amplifies the uncertainty effects on actual investment. We demonstrate that our results cannot be explained by intersegment investment transfer or financial constraints.

Keywords: Vertical integration, Investments, Uncertainty, Asset specificity

JEL Classification: D23, D25, D81