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Management Incentives, Signaling Effects and the Costs of Vertical Integration

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  • Sliwka, Dirk

    ()
    (University of Cologne)

Abstract

The costs of vertical integration are analyzed within a game-theoretic signaling model. It is shown that a company when being vertically integrated with a supplier may well decide to buy certain components from this supplier even at a lower quality than that offered by external sources. When the parent company decides to stop buying components from the integrated supplier, the value of the ownership share in the supplier is reduced: On the one hand, the supplier’s profit from the transactions with its parent is foregone. But on the other hand, other clients may decide against buying from this supplier as the latter’s reputation for providing an appropriate quality is damaged. The loss in value of the ownership share may outweigh the loss due to the lower quality. The anticipation of this effect leads to reduced ex ante incentives for the supplier’s management to raise quality. A spin-off may therefore be beneficial as it strengthens incentives. Costs and benefits of vertical integration are analyzed and consequences for vertically integrated companies organized in profit centers are discussed.

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Bibliographic Info

Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 856.

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Length: 40 pages
Date of creation: Aug 2003
Date of revision:
Publication status: published in: Zeitschrift für Betriebswirtschaft, 2004, 74 (1), 27-52
Handle: RePEc:iza:izadps:dp856

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Keywords: vertical integration; incentives; outsourcing; signaling;

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References

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  1. Oliver Hart & Sanford Grossman, 1985. "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration," Working papers, Massachusetts Institute of Technology (MIT), Department of Economics 372, Massachusetts Institute of Technology (MIT), Department of Economics.
  2. Masten, Scott E, 1984. "The Organization of Production: Evidence from the Aerospace Industry," Journal of Law and Economics, University of Chicago Press, University of Chicago Press, vol. 27(2), pages 403-17, October.
  3. Chiu, Y Stephen, 1998. "Noncooperative Bargaining, Hostages, and Optimal Asset Ownership," American Economic Review, American Economic Association, American Economic Association, vol. 88(4), pages 882-901, September.
  4. Hart, Oliver & Moore, John, 1990. "Property Rights and the Nature of the Firm," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 98(6), pages 1119-58, December.
  5. Jean Tirole, 1988. "The Theory of Industrial Organization," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262200716, December.
  6. Schmitz, Patrick & Dirk Sliwka, 1999. "On Synergies and Vertical Integration," Discussion Paper Serie A, University of Bonn, Germany 602, University of Bonn, Germany.
  7. Rosenkranz, Stephanie & Schmitz, Patrick W., 2001. "Vertikale Unternehmenskooperationen," MPRA Paper 6930, University Library of Munich, Germany.
  8. Schmidt, Klaus M, 1996. "The Costs and Benefits of Privatization: An Incomplete Contracts Approach," Journal of Law, Economics and Organization, Oxford University Press, Oxford University Press, vol. 12(1), pages 1-24, April.
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