Networks versus Vertical Integration

We construct a theory to compare vertically integrated firms to networks of manufacturers and suppliers. Vertically integrated firms make their own specialized inputs. In networks, manufacturers procure specialized inputs from suppliers that, in turn, sell to several manufacturers. The analysis shows that networks can yield greater social welfare when manufacturers experience large idiosyncratic demand shocks. Individual firms may also have the incentive to form networks, despite the lack of long-term contracts. The analysis is supported by existing evidence and provides predictions as to the shape of different industries.