Vertical Firm Boundaries: Supplier-Customer Contracts and Vertical Integration

I empirically examine the choice of a firm’s vertical boundaries—specifically, the decision to use supplier-customer contracts instead of either using markets or vertical integration. I examine the determinants of supplier-customer contracts using data on a customer’s contractual purchase obligations with its suppliers. Contracting propensity is positively related to supplier relationship-specific investments (RSI), the supplier’s relative bargaining power, and vertical integration costs, and negatively related to contracting costs, alternative sources of information about the customer, and the percentage of a customer’s input traded on financial markets. I also find that customer firms which have product market contracts with their suppliers have better relative performance. These performance effects are enhanced by relationship-specific investments and are robust to corrections for endogeneity. Additionally, I examine the choice between vertical integration versus supplier-customer contracts and find that the choice is predicted by the type of RSI. Consistent with theory, RSI measured using tangible (intangible) assets are positively related to integration (contracts). Further, positive (negative) shocks to industry-level intangible investment are related to increases in a firm’s contracting activity and decreases (increases) in the level of vertical integration, while positive (negative) shocks to industry-level tangible investment are related to decreases in contracting activity and increases (decreases) in the level of vertical integration. My results suggest that market frictions play an important role in shaping supplier-customer contracting activity and firm boundaries