Markets and Firms: A Search Approach to Spot-Trading and Vertical Integration

In this thesis, we study both firms and markets, but in an environment in which much greater attention is placed on the workings of the market than has been the case heretofore. Specifically, we analyze the make-or-buy decision within a dynamic environment, in which firms search for trading partners, and in which they can choose the optimal ownership form upon contact: either spot-trading or vertical integration. Chapter 1 begins by providing an overview of the problem, and by summarizing elements of the pertinent literature. Chapter 2 then analyzes market exchange versus vertical integration in the simplest environment: one composed of homogeneous upstream and downstream firms. In this setting, we assume that firms can enter the industry as either independent or vertically integrated. An upstream asset --- including one within a vertically integrated arrangement --- cannot produce every type of widget that may be required by a given downstream asset. This may force even vertically integrated firms to search for widgets produced by independent upstream firms. In contrast to other papers in the literature, we show that independent and integrated firms can co-exist in a non-knife-edge equilibrium. In Chapter 3 we then extend the simple model presented in Chapter 2 to allow for asset trading -- i.e., takeovers -- between independent upstream and downstream firms. In this setting, firms can enter the industry as independent entities. Upon meeting a given upstream/downstream pair can either simply spot-trade (and go their separate ways) or carry out a merger. Once again we show that independent and integrated firms generically coexist in equilibrium. Finally in Chapter 4 we introduce heterogeneity into the basic model in the form of different types of firms, and idiosyncratic productivity shocks. One of the main findings is the demonstration that search theory provides an appealing explanation for the observed âjumpsâ of an acquiring firm's stock-value before and after integration. An appealing feature of the approach is that a decline in shareholder value is not symptomatic of managerial malfeasance --- which is the usual interpretation advanced in the literature.