Supply Chain Control: A Theory of Vertical Integration

Improving a company's bargaining position is often cited as a chief motivation to vertically integrate with suppliers. This paper expands on that view in building a new theory of vertical integration. In my model firms integrate to gain bargaining power against other suppliers in the production process. The cost of integration is a loss of flexibility in choosing the most suitable suppliers for a particular final product. I show that the firms who make the most specific investments in the production process have the greatest incentive to integrate. The theory provides novel insights to the understanding of numerous stylized facts such as the e ffect of financial development on the vertical structure of fi rms, the observed pattern from FDI to outsourcing in international trade, the eff ect of technological obsolescence on organizations, etc.