A Price Theory of Vertical and Lateral Integration under Productivity Heterogeneity

We analyze the interplay between product market prices and firm boundary decisions. Enterprises are heterogeneous with respect to their productivities and each enterprise chooses between two ownership structures--centralized ownership (integration) performs well in coordinating managerial actions but ignores private costs; dispersed ownership (non-integration), on the other hand, overvalues private costs but is conducive to poor coordination. The equilibrium ownership structure is monotone, i.e., high-productivity enterprises integrate while the low-productivity ones stay separate. Product market price can be positively or negatively associated with the incidence of integration, depending on how a price change affects the endogenously determined distribution of surplus between the units that comprise an enterprise. As higher prices may result in less integration, the industry supply may be backward-bending. Our model delivers novel empirical and policy implications