Contractual Institutions, Financial Development and Vertical Integration: Theory and Evidence

This paper presents an industry equilibrium model of vertical integration under contractual imperfections with specific input suppliers and external investors. I assume that vertical integration economizes on the needs for contracts with specific input suppliers at the cost of higher fixed costs. I show that contractual frictions with external investors affect vertical integration through two opposing channels whose relative intensities depend on other determinants of firms size distribution in the industry. Using cross-country-industry data, I present novel evidence on the institutional determinants of international differences in vertical integration which is consistent with the predictions of the theoretical model. In particular, I show that countries with more developed financial systems are relatively more vertically integrated in industries that employ a high share of workers in large firms.