Vertical Integration as a Self-Enforcing Contractual Arrangement

A recent wave of large vertical mergers presents a challenge to established theories of vertical integration. The large mergers that have occurred in the pharmaceutical industry between drug manufacturers and companies that manage drug insurance benefits (such as Merck's acquisition of Medco) and in the entertainment industry between program suppliers and network distributors (such as Disney's acquisition of Capital Cities/ABC) do not seem to fit traditional economic theories of vertical integration. The proximate causes for these mergers are fairly obvious. The entertainment mergers have been motivated by regulatory changes that permit TV networks to own the product they distribute, and the drug industry mergers have been motivated by the demonstrated ability of drug insurance managers to influence the sales share of different patented drugs within a therapeutic category. However, it is not obvious why these changes in the market environment led to vertical integration. To illuminate the economic motivation for these recent vertical mergers, we present an analysis of vertical integration that combines and extends our work on self-enforcing contracts (Klein and Murphy, 1988; Klein, 1996) with earlier work on vertical integration to avoid holdups (Klein et al., 1978). In what follows we first show that competitive, nonfree-riding distributors often face a distorted incentive to supply the promotional services desired by manufacturers. We then explain why the usual contractual solution to this distributor "malincentive" problem is likely to combine court enforcement and self-enforcement mechanisms. Finally, we outline how vertical integration may facilitate such a self-enforcing contractual arrangement