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 may choose the intensity of specialization towards the needs of the buyer. A basic trade-off arises: While non-integration may lead to higher investment incentives, potential synergies are foregone. Hence, integration may be optimal even though only the supplier has to make an investment decision. Furthermore we show that if in addition to asset ownership the degree of specialization is contractible both parties will deliberately agree on an inefficiently low level of specialization since this improves investment incentives