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A Price Theory of Vertical and Lateral Integration under Two-Sided Productivity Heterogeneity

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  • Serfes, Konstantinos

    ()
    (School of Economics LeBow College of Business Drexel University)

Abstract

Organizational design (firm boundaries) is an important aspect of a firm's internal structure and is affected by market conditions. Our main focus in this paper is on firm boundaries - firms' integration decisions - and how these decisions interact with product market competition, in a setting where firms in the market are heterogeneous with respect to their productivity. Existing research in the organizational industrial organization (OIO) literature has highlighted a price effect, which affects firms' integration incentives. We identify a second effect (revenue share effect) which works in the opposite direction from the price effect. The revenue share effect arises,very naturally, to ensure a stable equilibrium, when heterogeneous firms match endogenously in the market, and has profound implications for organizational design. We show that integration decisions can be non-monotonic with respect to firm productivity. Moreover, depending on the market distribution of firm productivities, a higher market price can induce more or fewer firms to integrate. In the latter case, the industry supply curve can be backward-bending. Market equilibria can be ownership inefficient, with 'too much' or 'too little' integration. These results are in contrast to existing literature and generate new empirical and policy implications.

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Bibliographic Info

Paper provided by LeBow College of Business, Drexel University in its series School of Economics Working Paper Series with number 2013-6.

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Length: 37 pages
Date of creation: 26 Nov 2013
Date of revision: 06 Mar 2014
Handle: RePEc:ris:drxlwp:2013_006

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Web page: http://www.lebow.drexel.edu/
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Keywords: Integration; incomplete contracting; market competition; endogenous matching; two-sided firm heterogeneity;

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  17. Morten Sørensen, 2007. "How Smart Is Smart Money? A Two-Sided Matching Model of Venture Capital," Journal of Finance, American Finance Association, vol. 62(6), pages 2725-2762, December.
  18. Konstantinos Serfes, 2008. "Endogenous matching in a market with heterogeneous principals and agents," International Journal of Game Theory, Springer, vol. 36(3), pages 587-619, March.
  19. Serfes, Konstantinos, 2005. "Risk sharing vs. incentives: Contract design under two-sided heterogeneity," Economics Letters, Elsevier, vol. 88(3), pages 343-349, September.
  20. Chad Syverson, 2010. "What Determines Productivity?," NBER Working Papers 15712, National Bureau of Economic Research, Inc.
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