Vertical Integration, Missing Middle and Investor Protection in Developing Countries

The industrial organization of developing countries is characterized by: (i) pervasive use of subcontracting arrangements among small firms, (ii) "missing middle" in the firm size distribution, and (iii) financially constrained firms.  This paper studies an incomplete contract model in which the integration decision is chosen to maximize the returns of two vertically related projects to an external investor.  The model jointly determines the financing, size and organization of firms.  Vertical integration trades-off the benefits of joint liability against the cost of rendering the supply chain more opaque from the point of view of investors.  The model shows that vertical integration is more likely to arise for intermediate levels of investor protection and that better contract enforcement reduces vertical integration only if financial markets are sufficiently developed.  Moreover, the firm size distribution is more likely to display a missing middle in industries which favor vertical integration.  The model sheds light on the industrial organization of developing countries showing that the motives for vertical integration are not necessarily higher in those countries.