On Synergies and Vertical Integration

We analyze in an incomplete contracts model whether a supplier should be integrated if in addition to his investment level he chooses the intensity of specialization towards the buyer's needs. A basic trade-off arises: While non-integration leads to higher investment incentives, potential synergies are foregone. Hence, integration can be optimal even though only the supplier makes an investment decision. This may also yield some insights for the discussion on which activities belong to a firm's core competencies. Furthermore, we show that if specialization is contractible, underspecialization will deliberately be chosen since investment incentives are thereby improved.