Do prices determine vertical integration?

This paper shows that product prices determine organizational design by studying how trade policy affects vertical integration. Property rights theory asserts that firm boundaries are chosen by stakeholders to mediate organizational goals (e.g., profits) and private benefits (e.g., operating in preferred ways). We present an incomplete-contracts model in which vertical integration raises output at the expense of lower private benefits. A key implication is that higher prices should result in more integration, since the organizational goal becomes relatively more valuable than private benefits. Trade policy provides a source of exogenous price variation to test this proposition: higher tariffs should lead to more vertical integration; moreover, ownership structures should be more alike across countries with similar levels of protection. To assess the evidence, we construct firm-level indices of vertical integration for a large set of countries and industries and exploit cross-section and time-series variation in import tariffs to examine the impact of prices on organizational choices. Our empirical results provide strong support for the predictions of the model.