A Price Theory of Vertical and Lateral Integration under Two-Sided Productivity Heterogeneity

Organizational design (firm boundaries) is an important aspect of a firm's internal structure and is affected by market conditions. Our main focus in this paper is on firm boundaries - firms' integration decisions - and how these decisions interact with product market competition, in a setting where firms in the market are heterogeneous with respect to their productivity. Existing research in the organizational industrial organization (OIO) literature has highlighted a price effect, which affects firms' integration incentives. We identify a second effect (revenue share effect) which works in the opposite direction from the price effect. The revenue share effect arises,very naturally, to ensure a stable equilibrium, when heterogeneous firms match endogenously in the market, and has profound implications for organizational design. We show that integration decisions can be non-monotonic with respect to firm productivity. Moreover, depending on the market distribution of firm productivities, a higher market price can induce more or fewer firms to integrate. In the latter case, the industry supply curve can be backward-bending. Market equilibria can be ownership inefficient, with 'too much' or 'too little' integration. These results are in contrast to existing literature and generate new empirical and policy implications.