Preliminary draft, comments welcome Institutional Determinants of Vertical Integration: Evidence from China

In a world with no transaction costs, vertical integration is intrinsically inefficient because it reduces specialization and thus the exercise of comparative advantage among firm units. However, in reality transactions between separate firms carrying out vertically related activities have costs stemming from weak property rights protection, information asymmetry, or agency behavior, all of which lead to anticipated opportunistic behavior and ex ante distortions in investment. If these transaction difficulties cannot be overcome by contracting, because of weak institutions or insufficient market disciplinary forces, vertical integration can be a solution. Politically connected corporate insiders can use vertical integration to enhance their rent-seeking returns, though these are likely not shared with outside shareholders if this can be avoided. Empirical validation of these hypotheses is most likely in emerging economies, where legal and market institutions are often weak despite substantial variation across sub-regions. Using Chinese data, we find that vertical integration is indeed importantl