Determinants of Vertical Integration: Trade Policy, Contracts and
Technology
Luigi Pascaliy
Pompeu Fabra University and Barcelona GSE
Current Version: 22 December 2012
First version: 11 January 2009
Abstract
This paper studies the e¤ects of international openness and contracting institutions on vertical
integration. It …rst derives a number of predictions regarding the interactions among trade barriers,
contracting costs, technology intensity, and the extent of vertical integration from a simple model
with incomplete contracts. Subsequently, it investigates these predictions using a unique dataset
of more than 20,000 …rms operating in 82 countries. Consistent with theory, the e¤ect of the
technology intensity of domestic producers on their likelihood to integrate vertically is decreasing in
the quality of domestic contracting institutions and in international openness. Contract enforcement
costs are particularly high in developing countries, and their e¤ects on the vertical structure of
technologically intensive …rms may have signi…cant welfare costs. If improving domestic contracting
institutions is not feasible, then an equivalent solution is to increase openness to international trade,
which would discipline domestic suppliers and thereby reduce the need for vertical integration.
JEL: D23, F13, L23
Keywords: Vertical integration, Hold-up, Incomplete contracts, International Trade
An earlier version of this paper was circulated under the title "Contract Incompleteness, Globalization and
Vertical Structure: an Empirical Analysis".
y
I would like to thank James Anderson, Susanto Basu, Kit Baum, Matteo Cacciatore, Fabio Ghironi, Simon
Gilchrist, Fabio Schiantarelli, Luis Serven, Maurizio Zanardi and partecipants at ISNIE 2008 and EEA 2009 conferences, and seminars at Bocconi University, Boston College, Boston University, CREI, Pompeu Fabra University and
University of Pavia. Contacts: Luigi.Pascali@upf.edu
1
1
Introduction
Anecdotal evidence suggests the presence of substantial heterogeneity in the vertical structure of
production across countries. Some observers relate this phenomenon to di¤erences in institutional
environments and trade openness. For example, Khanna and Palepu (2000) provide evidence that
companies in India are larger and more vertically integrated than those in the US and suggest that
this di¤erence occurs because trading at arm’s length is more costly in developing countries, in
which contract enforcement is weaker. The Economist (1991) notes that the Japanese companies
are less vertically integrated than Western companies, although an increase in foreign competition
is leading to a "Japanization" of the Western companies1 .
The primary aim of this paper is to o¤er an initial attempt to analyze how domestic contract
enforcing institutions and openness to international trade jointly a¤ect the vertical structure of
…rms, using a novel theoretical model and testing its predictions on a unique cross-country …rmlevel data set.
Two well-established theories o¤er predictions regarding how di¤erences in contracting institutions among countries could a¤ect the vertical organization of …rms. Both of these theories relate
the vertical structure of …rms to the "hold-up" problem of underinvestment. Consider the common
situation in which aggregate pro…ts depend on the investment of each parties and in which these
investments are relationship-speci…c in the sense that they are sunk outside of the business relationship. If these investments are not contractible once they have been made, then opportunism
may arise. This possibility can lead ex-ante to under-investment and ex-post to ine¢ cient economic performance. Transaction costs economics (TCE) theories assume that vertical integration
solves the hold-up problem at a …xed cost and that this integration should thus be prevalent when
contracts are more di¢ cult to write. In contrast, property rights theories (PRT) emphasize that
vertical integration does not automatically solve the under-investment problem because employees
must also be given incentives to invest and because their lack of ownership of tangible assets may
weaken their incentives to invest even in a vertically integrated entity2 .
1
Other studies have emphasized the di¤erences between Emilia Romagna, an Italian region, and the rest of Europe
(Johnston and Lawrence, 1998) and between South Korea and Taiwan (Levy,1991). Fan e al. (2009) documented
di¤erences across Chinese regions.
2
TCE theories were pioneered by the recently Nobel laureate Oliver Williamson (1975, 1985), while PRT theories
were originally developed by Grossman and Hart (1986) and Hart and Moore (1990).
2
Also the theoretical literature on the e¤ects of international trade on vertical integration is
inconclusive. For example, in McLaren (2000) buyer-supplier pairs are located in the same country
and simultaneously choose whether to vertically integrate or outsourcing. The integration of a
pair produces a negative externality because it thins the secondary market and reduces the outside
options for non-integrated …rms. In this world, trade openness partially increases incentives for
outsourcing by thickening the secondary market. Market thickening is also cited by Grossman and
Helpman (2002) as a reason that trade openness increases the advantages of outsourcing. In their
model, thickened secondary markets imply lower matching costs between producers and suppliers3 .
On the other side, Ornelas and Turner (2008) show that by increasing the gains from becoming
a multinational corporation with respect to domestic outsourcing, trade openness may actually
increase the vertical integration of domestic …rms4 . Also in Conconi, Legros and Newman (2012)
the e¤ect of international trade on vertical integration is ambiguous. Managers decide whether to
integrate or not their respective plants trading o¤ pecuniary bene…ts from coordinating production
decision with the private bene…ts of operating in their preferred way their own plant. In this setting,
the price of output is a crucial determinant of the organizational choice: at higher prices managers
value the pecuniary bene…ts from the increase in output brought by integration more than the
private costs in terms of the lost organizational control. This design is embedded in a standard
two-countries speci…c factor model: under general conditions, moving from autarky to free trade
increases the price of output in one country and reduces it in the other one, implying opposite
e¤ects on the integration of …rms in the two countries.
In sum, the e¤ects of both contracting institutions and trade openness on vertical integration
are potentially ambiguous and a better understanding of these relationships requires an empirical
3
Antras (2003) and Antras and Helpman (2004) embeds a property right approach in a general equilibrium, factor
proportion model of international trade with imperfect competition and product di¤erentiation. The model pins
down the boundaries of multinational …rms as well as the international location of production. A reduction of tari¤s
increases the propensity to international outsourcing relative to multinational vertical integration. Also in Mendi
(2011), a reduction in tari¤s decreases the propensity of …rms to vertically integrate. In this work, forward vertical
integration occurs for strategic reasons, namely to create a mechanism that allows a domestic upstream monopolist to
discipline non-integrated domestic downstream oligopolists and sustain pro…table collusion. Since the world market
is assumed to be competitive, an import tari¤ imposes a cap on the domestic …nal good price. In this setting, a
reduction in the import tari¤ decreases the monopoly pro…t and therefore the incentives to vertically integrate to
sustain collusion.
4
Ornelas and Turner (2008) adapt a TCE approach to a particular international context and consider a classical
hold up situation between a domestic downstream …rm and a foreign upstream …rm. Under vertical integration,
investment is higher and, as consequence, the expected trade volumes are larger. In this context, trade liberalization
might be more bene…cial to vertically integrated …rms than to …rms that operate at arm’s length.
3
investigation.
Before proceeding to the empirical analysis, in the …rst part of the paper, I present a theoretical
model in the spirit of TCE theories that examines how these forces contribute to shaping the
governance structure of …rms. The model uses the canonical "hold-up" framework but it extends
it to introduce competitive foreign markets and to produce a set of testable predictions. A …nal
good producer makes certain investments that become fully productive, depending on whether the
domestic supplier decides to collaborate. Ex-ante the two parties can either vertically integrate at
a …xed cost or sign a contract that will be enforced ex-post with a certain probability. In case it
is not enforced, the two parties can renegotiate the contract or the investor can turn to a foreign
supplier at the cost of paying an import tari¤. In the data, …rms are distributed according to a
continuous spectrum of levels of vertical integration. To capture this feature, my model assumes
that the investor has access not to a single investment but to a continuous set of investments,
characterized by di¤erent levels of asset speci…city, which is modeled as the part of the investment
that becomes unproductive without the collaboration of the respective supplier.
The model produces a set of predictions that can be tested in the data. First, the combination of
greater asset speci…city and lower contract enforcement implies underinvestment under outsourcing
and therefore increases the incentive to vertically integrate. In addition, the model predicts another
interaction e¤ect of asset speci…city and trade barriers. The ability of an investor to …nd other
partners in other countries limits the ability of his domestic partner to hold him up. Therefore, lower
trade barriers discipline the partners of investors and attenuate the distortions that are generated
by the low quality of domestic institutions.
The model di¤ers from the previous literature on several dimensions. First, the speci…city of
investments, the level of vertical integration, the quality of contracting institutions and the openness
to international trade are classi…ed according to a continuous measure to facilitate comparative
statics on this variables. Second, it predicts that an increase in trade openness can lead to changes
in the ownership structure within countries, even if …rms do not relocate across countries and even
if international trade does not change, by simply disciplining domestic partners.
I test the predictions of the model using detailed data on more than 20,000 …rms operating in 82
countries. This data set is obtained by aggregating a large number of country-speci…c ICA World
Bank Surveys and provides, among the other, information on the vertical structure and technology
4
intensity of …rms. The main dataset is then merged with the Doing Business Database, which
provides country data on institutional features, and the TRAIN Database, which provides data on
tari¤s.
The regressions show that vertical integration is less likely when capital intensity is associated
with trade openness and high-quality contracting institutions; thus the predictions of the theoretical
model are con…rmed. This result suggests that opening up to international trade may produce the
same attenuation to the hold-up distortions as improving domestic contract enforcement. In the
most credible speci…cation, the reduction of input tari¤s by 1% produces the same e¤ects on the
vertical structure of a …rm, characterized by the median machinery intensity, as a reduction by
3.06% in the cost necessary to solve a commercial dispute in local courts or a reduction by 1.4 in
the number of days necessary to close the dispute. These results are practically una¤ected when
controlling for …rm size, foreign ownership and market power. To cope with potential endogeneity
issues in the capital intensity of …rms, I use an IV approach that exploits exogenous variations in
the level of asset speci…city that is generated by technological di¤erences across sectors. Speci…cally,
I use six di¤erent measures of asset complexity within the same industry in the United States as
instruments for capital intensity. In addition, I conduct a number of robustness checks and …nd
that the results are robust to a wide variety of speci…cations.
To the best of my knowledge, this is the …rst study that tests the e¤ect of trade openness on
vertical integration in a cross-country empirical analysis5 . Moreover, this paper contributes to a
recent stream of empirical research on the e¤ects of the institutional environment on the vertical
boundaries of …rms. In particular, Macchiavello (2012) uses the UNIDO industry-level database
to study the e¤ects of …nancial development on the average vertical integration in the industry,
while Acemoglu, Johnson, Mitton (2009) use a business contact dataset, to study how …nancial
development and contract enforcing costs interact to shape the vertical structure of …rms. A
potential bene…t of using the ICA World Bank surveys with respect to the datasets used by these
two studies is that they provide …rm-level information on the asset speci…city of …rms and, thus,
allow to capture heterogeneous e¤ects of the institutional environment on the vertical boundaries
5
In a parallel contribution, Chungvilaivan and Hur (2012) examine the relationship between trade openness and
the pattern of vertical integration using US manufacturing data. In particular, they document a negative relationship
between import penetration and the propensity of …rms to vertically integrate, particularly pronounced in more
concentrated industries.
5
of …rms operating in the same industry. Two other interesting works that test the institutional
determinants of vertical integration, but in a single-country analysis are those of Fan et al (2009),
which exploits institutional variation across di¤erent Chinese provinces, and Acemoglu et al. (2010),
which investigates the validity of PRT theories using data on the census of manufacturing plants
in Great Britain.
In sum, my work provides an empirical analysis of the institutional determinants of vertical
integration using a cross-country database. This study is the …rst one to use a cross-country database to evaluate the role of tari¤s and it adds further evidence on the role of contract enforcement
institutions. Policy advice emerges from both the theoretical and empirical analyses of the paper.
When associated with speci…c assets, poor contract enforcement can distort the vertical structure
of …rms and thus have signi…cant welfare costs. If improving home institutions is not feasible, then
an equivalent solution is to reduce the trade barriers to the import of intermediates. This reduction
would discipline domestic suppliers and increase the incentives of producers to invest in speci…c
assets. An alternative way to interpret this result is that reducing trade barriers is a way of "importing" foreign institutions, as domestic …rms will relate with one another as though the relevant
contracting institutions were those of the countries in which alternative suppliers are operating.
This paper is organized as follows. Section 2 details the theoretical framework and derives some
testable implications. Section 3 presents the main empirical results and several robustness checks.
Some concluding remarks close the paper.
2
The Model
2.1
Basic Structure
A …nal good producer (P) at Home (H) seeks to buy an input that enhances the productivity
of his investments. There is a speci…c supplier (HS), whose characteristics are most suitable for
providing the input to …rm P and that is also located at H. P could either outsource to HS or
become vertically integrated with her.
Under outsourcing, the two parties write a contract on the price of the intermediate good
before the speci…c investment is realized. However, because of contract incompleteness, there is a
probability that this agreement will be broken after the speci…c investment has been realized. At
6
this point, a new agreement must be reached. However, the bargaining power of HS is much higher
than before because the producer’s speci…c investment is partially sunk without the intermediate
good. The amount with which HS can hold-up P depends on the possible alternatives that the latter
has to buy a similar intermediate elsewhere. I assume that P can purchase the same intermediate
from a foreign supplier (FS) located in a competitive market. Ex-ante (e.g., before the speci…c
investment has been undertaken), the price of the foreign intermediate, pF , is a random variable
with randomness that re‡ects both shocks to the productivity of FS and shocks to the exchange
rates. Moreover, when importing an intermediate, the producer must pay a trade cost t. Ex-ante,
the probability of …nding an alternative intermediate depends on the trade costs. If this probability
is low, for example because trade barriers are excessively high and buying in another country is not
feasible, then the producer knows that most of the revenues that are derived from his investment
can be expropriated by HS. Therefore, the producer would have lower incentives to invest, which
would imply a suboptimal level of investments and ex-post ine¢ cient economic performance.
Under vertical integration, the two parties merge into a single …rm. As in Hart and Tirole
(1990), this option "permits pro…t-sharing between upstream and downstream units so all con‡icts
of interest about prices and trading policies are removed". The advantage of this option is that an
e¢ cient level of speci…c investments is realized; the disadvantage is that it requires a …xed cost.
The presence of a …xed cost related to the vertical integration choice is a common feature in this
body of literature (see Hart and Tirole, 1990; McLaren, 2000; Ornelas and Turner, 2008) and can
be interpreted as a means of capturing all of the legal, …nancial and organizational costs that are
involved when merging two …rms.
In sum, the choice between vertical integration and outsourcing solves the trade-o¤ between
the …xed cost that arises under vertical integration and an ine¢ cient level of speci…c investments
that arises under outsourcing. Better contract enforcement and lower trade barriers attenuate the
relevance of the hold-up problem and the related investment distortions and thus increase incentives
for outsourcing.
The timing of the events in the model is summarized in Figure 1. At period 1, HS and P
decide whether to integrate; if they do not choose to integrate, then they sign an ex-ante contract
that de…nes the price of the intermediate input6 . At period 2, P makes its relationship-speci…c
6
Notice that I have ruled out the possibility that the producer could outsource to FS in the …rst stage of the game.
7
Home supplier and producer decide whether
to vertically integrate and reach an agreement
over the price of the intermediate input
If vertical
integration was
chosen
Stage 1
If outsourcing
was chosen
The producer chooses I and
the home supplier provides
the intermediate input
The producer chooses I
Contract not
enforced
Stage 2
Contract
enforced
Home supplier and producer bargain
over the price of the intermediate input
Home supplier provides
the specific input
Stage 3
If bargaining
breaks down
The producer chooses whether to buy the
intermediate input from a foreign supplier
Stage 4
Figure 1: The sequence of events
investments, I. At the beginning of period 3, the state of nature is revealed: the price of the foreign
intermediate (pF ) becomes public, and parties are informed as to whether the initial contract will
be enforced. If outsourcing was chosen, then with probability (1
) the initial contract is not
enforced and the two parties must bargain again over a new price7 . At period 4, P can decide
whether to buy the intermediate input from the foreign supplier FS.
The production technology of the producer has the following form:
f ( ; I; x) = (1
)g(I) + g(I)x
(HP1)
where I is the producer’s investment, and x is an indicator variable that is equal to one if the home
supplier provides the intermediate good that increases productivity and zero otherwise.
(0; 1)
corresponds to the share of the investment that is unproductive without the intermediate good and
captures the speci…city of the investment. The …rst term of the production function is the output
that the producer can eventually generate without any intermediate good. The second term is
the additional output that is generated by the producer conditional on the supplier providing the
intermediate good. Assume that:
There is no loss of generality in doing this since this alternative would be strictly dominated by the alternative to
outsource to HS (because outsourcing to FS has a …xed trade cost).
7
A similar way of modelling contract incompleteness as a determinant of vertical integration has been used by
Acemoglu, Johnson and Mitton (2009).
8
g 00 (I) < 0
(HP2)
Normalize the cost of one unit of speci…c investment to 1, and assume that HS can provide the
intermediate at no cost.
The game is solved by backward induction. In stage 4, if the producer still does not have the
intermediate input, then he will buy it from the foreign supplier if:
pF < g(I)
where
t
is a proxy for the appropriateness of the foreign intermediate input to the speci…c in-
vestment made by the producer. Let us consider a situation in which
(e.g. the domestic
intermediate is at least as e¤ective as the foreign one).
2.2
Stage 3: Expected Pro…ts under Outsourcing
In the third stage of the game, the producer has already made the investments and is outsourcing
the production of the intermediate good to the home supplier. Suppose that the initial contract
cannot be enforced and that the two parties must bargain over the price of the input. In the event
of disagreement, the two parties receive their outside option. The home supplier would make zero
pro…ts, whereas the producer could still …nd it pro…table to use the intermediate input that is
produced by the foreign supplier. Denote the outside option of party i under outsourcing by OiO .
Then:
OpO (I) = (1
) g(I) + [M axf0; g(I)
OsO = 0
t
pF g]
I
(1)
(2)
Denote the ex post payo¤s of party i by u0i . Then:
f
u0p (I) = g(I)
I
p
u0s = p
where p denotes the new price of the intermediate when bargaining is successful. According to
9
the Nash bargaining solution, the price p satis…es the following:
p = Arg max p0:5 [ g(I)
M axf0; g(I)
p
t
pF g
p]0:5
(3)
which implies:
p=
1
g(I)
2
1
M axf0; g(I)
2
t
pF g
(4)
Hence, under the symmetric Nash equilibrium, the surplus that the producer accrues under
outsourcing conditional on the lack of enforcement of the initial contract is as follows:
u0p (I) =
2.2.1
1
1
g(I) + M axf0; g(I)
2
2
t
pF g
I
(5)
Stage 2: Choosing the Optimal Investments
In the second stage of the game, the producer chooses the optimal investments. If the producer and
the home supplier are vertically integrated, then the producer will select the level of investments I
to maximize the joint variable pro…ts:
VI
= g(I)
I
(6)
The optimal level of investments under vertical integration I V I is de…ned by the …rst-order condition
g 0 (I V I ) = 1. If the producer is outsourcing to the home supplier, then the producer will choose the
level of investments I O to maximize the expected pro…ts:
E
O
p
= [g(I) P ]+(1
) 1
2
g(I)+(1
1
)M axf0;
2
g(I)
Z t
( g(I) t pF )dF (pF )g I (7)
0
where P is the price of the intermediate good as in the initial contract. Intuitively, the …rst term
represents the revenues that the producer would obtain if the initial contract is enforced; the second
term represents the revenues that the producer would obtain under autarky if the initial contract is
not enforced; the third term represents the additional revenues that the producer would receive in
10
the presence of international trade if the initial contract is not enforced (because of the improvement
in his outside option in the bargaining game with the domestic supplier); the last term represents
the investment costs. The optimal level of investments under outsourcing, I o ( ; ; t), is the level of
O.
p
investment that maximizes E
In general this function has more than one local maximum. The
following hypothesis limits the number of local maxima to two.
g 00 (I)
<
g 0 (I)2
1
) 12 2 f ( g (I) t)
) 12 (
F ( g (I) t))
(1
(1
(HP3)
Intuitively g (I) must be su¢ ciently convex (e.g., the marginal productivity of investments
must decrease more rapidly than the hazard rate of the price of the foreign intermediate). To
discuss the local maxima of the function E
(1
) (I; T ) where Q( ; ; I)
M axf0; 12
g(I)
R t
( g (I)
0
t
is convenient to rewrite it as: E O
P = Q( ; ; I) +
h
i
P C] + (1
) 1 2 g (I)
I and (I; t)
O
P
[g (I)
pF ) dF pF g. De…ne I (t) the minimum investment for which: (I (t) ; t)
0 and I ( ; ) the investment that maximizes Q( ; ; I). In other words, I (t) is the minimum investment necessary to make credible the threat of buying the intermediate from a foreign supplier
and I ( ; ) the optimal investment under autarky.
Lemma 1 If I ( ; ) > I (t), the pro…t function has a single local maximum in I
( ; ; t) iden-
ti…ed by the following equation:
1
If I ( ; )
(1
)
1
(
2
F ( g (I )
t)) g 0 (I
( ; ; t))
1
0
(8)
I (t), the pro…t function can have an additional single local maximum in I ( ; )
identi…ed by the following equation:
1
and such that: I ( ; ) < I
(1
)
2
g 0 (I ( ; ))
1
0
(9)
( ; ; t)
Thus, the pro…t function has at most two local maxima I ( ; ) and I
convexity of g(:) it is easy to verify that both I ( ; ) and I
( ; ; t). Given the
( ; ; t) are lower than I V I (e.g.
investments are always lower under outsourcing rather than under vertical integration). The en11
h
tity of underinvestment under outsourcing is proportional to 1
prohibitive (e.g. if I o ( ; ; t) = I ( ; )) and to (1
not (e.g. I o ( ; ; t) = I
) 21
(1
(1
)
2
i
if trade barriers are
) 12 F ( g (I)
t) if they are
( ; ; t)). The last expression is intuitive. The …rst term represents the
classical hold-up distortion that we …nd in the transaction cost literature. The interaction between
contract incompleteness and asset speci…city distorts the investment incentives to invest of the producer because a part of the surplus that is generated by the investments can be appropriated by the
supplier, and this situation produces suboptimal investments. The second term represents the e¤ect
of opening the intermediate market to international trade and is the main novelty of the model.
The ability of the producer to buy the same intermediate input with a certain probability from
a foreign supplier limits the possibility of holding him up and de facto attenuates the distortions
that are created by low-quality domestic institutions. In the limit, if trade barriers and foreign
prices are su¢ ciently low (e.g.,
2 F(
g(I O )
t) = 1), then the hold-up problem disappears. In this
sense, opening a country with bad contracting institutions to trade is a means of "importing" good
institutions. This logic leads to our …rst proposition (see the Appendix for the complete proof).
Proposition 2 Under outsourcing, the producer’s optimal investment is not increasing in t.
Notice that by applying the implicit function theorem on equations 8 and 9, one can prove
that both I ( ; ) and I
( ; ; t) are increasing in contract enforcement, , and decreasing in the
speci…city of the asset, . This result provides the intuition for the following propositions (see the
Appendix for the complete proof):
Proposition 3 Under outsourcing, the producer’s optimal investment is increasing in .
Proposition 4 Under outsourcing the producer’s optimal investment is decreasing in :
2.2.2
Stage 1: Choosing the Governance System
Because both parties have access to ex-ante transfers, the subgame perfect equilibrium will always
select the organizational form that maximizes their joint surplus. Consistent with the transaction
cost approach, it is hypothesized that vertical integration has a …xed cost . Let S V I ( )
IV I
refer to the joint surplus under vertical integration, and let S O ( ; ; t)
12
g(I V I )
g(I O ( ; ; t))
I O ( ; ; t) refer to the joint surplus under outsourcing. The comparison of these values yields the
following proposition.
Proposition 5 Vertical integration is more likely when assets are speci…c (
is high), contracts
are incomplete ( is low) and trade barriers are high (t is high).
= SV I ( )
Proof. The two parties will vertically integrate as long as
S O ( ; ; t) is positive.
To obtain an expression for the impact of higher asset speci…city on the governance of the …rms
consider the derivative of the latter with respect to .
d
d
Notice that
since 1
dI O ( ; ;t)
d
=
dI O ( ; ; t)
[1
d
g 0 (I O ( ; ; t))]
is not positive by proposition 4 and [1
(10)
g 0 (I O ( ; ; t))] is also not positive
g 0 (I V I ) = 0 and I O ( ; ; t)) < I V I (together with the convexity of g). Thus
Analogously it can be proven that
d
dt
0 and
d
d
d
d
0.
0.
The intuition behind the last proposition is straightforward. Higher levels of asset speci…city,
contract incompleteness and trade barriers tend to distort investments under outsourcing and thus
increase the e¢ ciency of vertical integration.
One problem when confronting this theoretical model with the data is the di¢ culty of classifying
…rms according on whether they are vertically integrated or not because, in the data, …rms are
distributed according to a continuous spectrum of levels of vertical integration. The model can
capture this feature if the producer has access not to a single investment but to a continuum of
investment opportunities I(k) with k [0; 1] ; each of which is characterized by a di¤erent level of
speci…city
k.
Without a loss of generality, assume that these investment opportunities are ordered
according to an increasing level of speci…city, such that
simplifying assumption that
speci…cally, assume that
k
k
k0
>
k
if and only if k 0 > k. Make the
is a continuous di¤erentiable function of k such that:
d k
dk
> 0. More
= (Ak); where A > 0 is a shifter and represents the sophistication
of the producer’s assets (i.e., higher values are associated with a higher average level of speci…city
of the investments). Finally, let k denotes the investment opportunity for which the producer is
indi¤erent as to whether to outsource the production of the input that renders the investment fully
productive. Based on the previous discussion, k is de…ned from the following identity:
13
SV I ( )
S O ( ; (Ak ); t)
0
(11)
The producer will undertake all of the investments that are available and outsource the production of the intermediate inputs that are necessary to render them fully productive only for the
investments such that k < k . Rather, for those investments such that 1 > k > k , the …rm
will choose to produce them internally. For these reasons, V I
1
k can be considered a valid
continuous measure of the level of vertical integration of the …rm.
Proposition 6 Firms are more vertically integrated when they use more sophisticated assets, contracts are more di¢ cult to enforce and trade barriers are high.
Proof. Using the implicit function theorem on equation 11, together with propositions 2, 3 and 4, we
dV I
dk
k
dV I
dI O dI O 0
dV I
dI O dI O 0
get:
=
=
> 0;
=
=[
(Ak )A] < 0 and
=
=[
(Ak )A] >
dA
dA
A
d
d
d
dt
dt
d
1 dV I
dV I 2
1 dV I
dV I 2
=
< 0 and
=
> 0:
0;
dAd
A d
dAdt
A dt
Proposition 7 The e¤ ects of the average level of asset sophistication of a …rm (A) on its vertical
structure are magni…ed when contracts are di¢ cult to enforce and trade barriers are high.
Proof. Using the implicit function theorem on equation 11, together with propositions 2, 3 and 4, we
1 dV I
1 dI O dI O 0
dV I 2
1 dV I
1 dI O dI O 0
dV I 2
=
=
=[
(Ak )A] < 0 and
=
=
=[
(Ak )A] >
get:
dAd
A d
A d
d
dAdt
A dt
A dt
d
0:
The traditional IO literature has emphasized the distorting e¤ects of asset speci…city on the
governance system of …rms in an institutional environment characterized by incomplete contracts.
Thus, it should not come as a surprise that di¢ cult contract enforcement ampli…es the distortive
e¤ects of asset speci…city.
The contribution that the last proposition o¤ers to this literature is that it proposes an escape
clause. In fact, the distortive e¤ects of asset speci…city on the vertical structure of a …rm in the
context of bad domestic contracting institutions can be dampened if the …rm has access to foreign
markets for intermediates. Note that there is no international trade in this model: in equilibrium
the producer will always buy the widget from the domestic supplier. However, the threat of being
replaced by a foreign supplier assists in disciplining the domestic supplier. As the latter can no
14
longer hold-up the producer, outsourcing does not produce distorted investments, and the two
parties are less likely to become vertically integrated.
In the next sections, the last two propositions will be tested empirically.
3
Empirical Analysis
3.1
Data and Measurement
My …rm-level data are obtained from the "Investment Climate Assessments" (hereafter ICA), a
set of …rm-level surveys administered by the World Bank in a large number of developed and
developing countries. Each survey contains questions regarding the characteristics of …rms (e.g.,
industry, ownership and business age), measures of economic performances (e.g., balance sheets
and information pertaining the number and quali…cation of workers) and measures of the business
climate (e.g., trade costs, lobbying activity, bureaucratic delays, infrastructure, product and labor
market regulations). I have used a limited subset of the information that is provided in these
large surveys. In particular, I have used data pertaining to output value and intermediate costs
to measure the degree of vertical integration of the …rms in the sample, information regarding the
net book value of machinery and equipment to measure their capital intensity and information
regarding the number of workers, the ownership structure, the share of the domestic market and
the industry in which they operate. I have rearranged these variables in each country survey to
render them comparable across countries8 . Ultimately, the …nal dataset covers 20,216 …rms in 82
countries. New additional country surveys are implemented each year; thus the data cover di¤erent
periods for di¤erent countries, ranging from 2003 to 20099 .
Vertical integration is proxied by the value added over sales ratio, which should move consistently with the number of processes performed by the …rm10 . This ratio takes out the monetary
dimension and is comparable across countries without running into exchange-rate and purchasing
8
Details are available in the Appendix.
In the ICA data, the great majority of …rms are surveyed only once. For a very limited number of countries,
however, some …rms are surveyed up to three years. In this study, I have chosen to disregard the panel dimension and
conduct a purely cross-sectional study. Whenever more observations of the same …rm are available, only the most
recent one is considered.
10
A large empirical literature has already used this measure for vertical integration (see for instance, Adelman
(1955), Gort (1962), Nelson (1963), La¤er (1969), Tucker and Wilder (1977), Levy (1985), Barney, Edwards and
Ringleb (1992), Shin (2001), Bender (2002), Macchiavello (2008)).
9
15
power parity problems in terms of comparability. It will be close to one in the case of high vertical
integration and close to zero for …rms that add only marginal value to purchased inputs. Maddigan
(1981) pointed out that this measure has two mayor drawbacks. The …rst is that it is in‡uenced by
forces other than vertical integration, especially pro…tability. I will control for this in the empirical
analysis. However, it is reassured to notice that Tucker and Wilder (1977) compared a value-added
ratio corrected for pro…ts in the numerator and in the denominator with one not corrected: the use
of one series instead of the other did not a¤ect any result. The second drawback of value added
ratio is that is susceptible to a bias when it is used along an industry value chain because the
ratio is decreases along the value chain from upstream to downstream. However, as Levy (1985)
and Bender (2002) pointed out, this bias is signi…cantly reduced when restricting the sample to
manufacturing …rms.
Asset speci…city is proxied by the machinery intensity of the …rm, computed as the ratio of the
value of the machinery and equipment used in the production to total sales. Alternative measures,
used in the 2SLS analysis, are imputed from the Compustat database using the average intensity
of …xed assets and intangible assets in the corresponding industry in the United States11 .
Country-level data pertaining to the institutional environment are provided by the Doing Business database (hereafter designated DB). This database represents my primary source of data
regarding the quality of contract-enforcing institutions and …nancial development. More speci…cally, DB provides me with three di¤erent variables to proxy for the e¢ ciency of the judicial system
in resolving a commercial dispute: the time that is necessary to enforce a contract when it is being
disputed in courts, the costs that are associated with this enforcement and the average number of
documents that are needed. All of these variables refer to a claim that is assumed to be equivalent
to 200 percent of the average income per capita and have been inferred through studies of the
codes of civil procedure and other court regulations as well as surveys completed by local litigation
lawyers and judges.
Moreover, the DB database reports two measures on the level of development of national …nancial institutions that are used in my analysis: an index on the strength of legal rights in the
…nancial sectors and an index on the depth of credit information. The …rst one measures the de11
Machinery intensity and capital intensity have been largely used as proxies for asset speci…city in several empirical
studies on the determinants of the …rm boundaries (see for instance Nunn (2007), Acemoglu, Johnson and Mitton
(2009), Almeida, Campello and Hackbarth (2011), Chongvilaivan and Hur (2012)).
16
gree to which collateral and bankruptcy laws protect the rights of borrowers and lenders and thus
facilitate lending; the second one evaluates the rules and practices a¤ecting the coverage, scope
and accessibility of credit information available through either a public registry or a private credit
bureau.
Trade barriers to the imports of intermediate goods are measured using data on tari¤s from
the UNCTAD TRAINS database in addition to the input/output accounts that are published by
the Bureau of Economic Analysis. More speci…cally, the TRAINS database provides data on the
average (e¤ectively applied) tari¤s in each country at the 4-digits SIC code. These SIC codes are
subsequently matched with the appropriate 6-digits IO codes using the BEA’s concordance guide.
The input tari¤ in a certain industry is then constructed as a weighted average of the output tari¤s
in those industries from which it receives its inputs using cost shares as weights.
Table 1 sums up how theory is related with data and presents the proxies for vertical integration
and its main determinants.
Table 1: Measures used in the empirical analysis
Variable
Vertical integration
Proxy
Value added / Total sales (ICA)
Asset speci…city
Machinery,equipment/ Total sales(ICA)
Contract incompleteness
Contract enforcement costs (DB)
Contract enforcement procedures (DB)
Contract enforcement time (DB)
Trade barriers
Average tari¤s (TRAINS)
Average tari¤s on inputs (TRAINS+BEA)
Table 2 summarizes the distribution of observations across countries. Most of the countries
that are considered are low-income countries, but there are a number of exceptions (for instance,
the Czech Republic, Slovakia and Croatia). Income per capita ranges from $249 in Congo to
$25553 in the Czech Republic. The sample size varies considerably across countries: for example,
there are 22 observations in Montenegro compared with 1172 observations in Thailand. Limited
information is provided regarding how the sample is selected in each country, but in general the
typical ICA respondent is a large, mature business relative to the representative business in the
17
country (Haltiwanger and Schweiger, 2004).
Table 3 provides some descriptive statistics for the variables that are used in the empirical
analysis.
The …rst …ve rows consider …rm-level variables that are constructed from the ICA database.
Row 1 reports descriptive statistics for the vertical integration index at the …rm level. Observations
are fairly distributed around 0.6 (the mean and median have same value) from values that are close
to zero to values that are close to one. Row 2 reports the proxy for asset speci…city, namely, the ratio
of the net book value of machinery and equipment over the total sales of the …rms. The average
ratio is 0.22, which is less than half of the analogous US average in the manufacturing sector, which
is 0.45. This con…rms that using US data to impute the capital intensity of …rms in other countries,
as in Acemoglu, Johnson and Mitton (2009), may lead to misleading estimates. Row 3 reports the
average number of permanent workers at the …rm level. Both the mean and median (127 and 30,
respectively) show that the typical ICA respondent is large relative to a representative business
for a country. This is con…rmed in raw 4, which reports …rm’s share of national market of the
main product line (on average above 18%). Row 5 reports the share of the …rm that is foreign
owned. More than 14% of the …rms in the sample have some foreign participation (above 1%) in
the ownership structure and half of them are 100% owned by foreign privates.
The following three rows report the three di¤erent measures of the quality of contract-enforcing
institutions coming from the Doing Business database. The average commercial sale dispute in
local courts in my sample has an average cost of more than one-third of the claim and requires a
total of 37 legal procedures and 600 days to resolve. These numbers are high compared with their
US counterparts (14.4%, 32 and 300, respectively). Moreover, although the number of procedures
does not di¤er greatly across countries, there is substantial heterogeneity in the other two measures.
Rows 9 and 10 report the two measures of the quality of the …nancial system. Row 11 is the GDP
per capita in 2009. The GDP estimates are PPP adjusted and are obtained from the Penn World
Table database.
The following three rows report the average tari¤s on respectively intermediate inputs imported
from all countries, intermediate inputs imported from high-income OECD countries and …nal goods
imported from all countries. Finally, rows 15 through 20 report six di¤erent measures of capital
intensity at the industry-level computed from the US Compustat data set.
18
3.2
Empirical Results
Proposition 5 predicts that opening up to international trade and improving contract enforcement
institutions should reduce the likelihood of …rms to vertically integrate. Unfortunately, testing
these predictions is a di¢ cult task since a long list of potential omitted country-level variables
correlated with contract enforcement and trade openness may a¤ect the governance of the …rm.
However, the model provides a possible methodology to handle these unobservables that consists
in focusing on the interaction e¤ects of contracts and trade barriers with the machinery intensity
of a …rm and adding a set of country dummies in the regression. In this respect, proposition 7
predicts that the e¤ects of asset speci…city on the vertical structure of …rms are magni…ed by bad
contracts and high trade barriers. The following regression tests this proposition:
V If sc =
1 ASf
+
2 CIc ASf
+
3 T Bcs ASf
+ X 0 + Sc + Ss + "f sc
(12)
where V If sc and ASf sc are the vertical integration and machinery intensity of …rm f in country c
in sector s, CIc is the cost to enforce a contract in country c, T Bcs is the tari¤ on intermediates
in country c in sector s and X 0 is a vector of control variables. Finally, Sc and Ss are the country
and industry …xed e¤ects, respectively.
Column 1 of Table 4 reports the OLS estimates of the following equation: note that all of the
signs are consistent with the theoretical predictions. For an interpretation of the magnitude of the
coe¢ cients, Figure 2 depicts the marginal e¤ect of machinery intensity on the vertical structure of
a …rm as a function of trade barriers and contract enforcement costs. The …rst graph shows how
the marginal e¤ect of asset speci…city on vertical integration changes as importing costs change
(with contract enforcement costs …xed at their mean level). For sectors in which there are no
tari¤s on the import of intermediates, I cannot reject the hypothesis that asset speci…city has no
signi…cant e¤ect on vertical integration. However, as trade barriers become higher, the e¤ect of
asset speci…city becomes positive and signi…cant. The second graph depicts the marginal e¤ect of
asset speci…city as the cost of enforcing contracts varies. As expected, the e¤ect is much larger as
these costs increase.
This result suggests that improving the judicial system and reducing import barriers are two
substitute policies to attenuate hold-up distortions. More speci…cally, a reduction in tari¤s by one
19
percentage is associated with the same e¤ect on the vertical structure of a …rm as a reduction in
the cost of judicial disputes by 12.7 percentage points.
However, two potential concerns apply to the OLS estimates that we have seen so far. First,
several omitted …rm-level variables could be driving both the asset speci…city and vertical integration of the …rms in my sample. Second, the estimates may su¤er from a potential reverse causality
problem. For example, …rms that are more vertically integrated may be more likely to perform
primary activities that are less technologically intensive and require less speci…c assets. In both
cases, the error term would be correlated with the regressors, biasing the estimates.
A more satisfactory approach would involve conducting an instrumental variable analysis. The
following results exploit an exogenous source of variation in the level of asset speci…city that results
from technological di¤erences across sectors. More speci…cally, I instrument the machinery intensity
of a …rm in a certain industry using six di¤erent measures of average asset sophistication within
the same industry in the United States: the ratio of …xed assets and of the sum of …xed and
intangible assets to sales, total assets and number of employees. These variables are computed from
the US Compustat dataset12 . The following exclusion restrictions are implied by the IV strategy:
(1) conditional on the controls that are included in the regression, capital intensity in the US
has no e¤ects on the vertical structure of non-US …rms, if not through its correlation with their
machinery intensity, and (2) no unobservables are systematically correlated with capital intensity in
a certain US industry and the vertical structure of non-US …rms operating in the same industry. A
possible concern is that the latter condition may be violated if there are common industry-speci…c
unobservables across-countries. To address this issue, I will use industry …xed e¤ects throughout
the remainder of the analysis. This approach implies that it is impossible to identify the marginal
e¤ect of asset speci…city on the vertical structure of …rms; rather, it is only possible to determine
how this e¤ect varies with the contractual institutional environment and the trade openness of each
country.
The …rst-stage equations for the model in equation 12 are as follows:
ASf
CIc = Z 0 CIc
11
+ Z 0 T Bcs
12
+ X0
13
+ Sc + Ss + u1f
(13)
12
Acemoglu, Aghion, Gri¢ th and Zilibotti (2010) were the …rst to propose this instrument for asset speci…city in
a …rm-level analysis limited to UK manufacturing plants.
20
ASf
T Bcs = Z 0 CIc
21
+ Z 0 T Bcs
22
+ X0
23
+ Sc + Ss + u2f
(14)
where Z is the vector of instruments for asset speci…city (in other words, capital intensity in the
same industry in the US). Column 2 in Table 4 reports the IV estimates of equation 12. The instrumental variable strategy con…rms that the e¤ect of machinery intensity on the vertical structure
of a …rm is increasing in the cost of enforcing contracts and in the tari¤s on intermediates. Note,
however, that the magnitude of the coe¢ cients on the two interaction terms increases substantially
with respect to the previous OLS estimates. In particular, an increase of one standard deviation in
the cost of enforcing contracts (holding asset speci…city constant at its mean) leads to an increase
in vertical integration of more than a one-fourth of a standard deviation. Moreover, decreasing
the tari¤s on intermediates by 1% produces the same attenuation of the hold-up distortions on the
organization of production as a 3.06% reduction in the cost of enforcing contracts. For instance,
suppose that Burundi (in which CI is 39.31%, 75th percentile) could reduce the cost of enforcing
a contract to the same level as in Estonia (in which CI is 19.96%, 25th percentile). This reduction would produce the same e¤ect on the vertical structure of the …rms operating in Burundi as
reducing the average level of tari¤s on intermediate inputs from 8.14% to 1.82%.
Several authors have argued that, within industries, vertical integration is highly correlated with
the size of …rms (see for instance, Whinston (2003), Banerjee and Munshi (2004) and Macchiavello
(2012)). Moreover, …rm size is a¤ected by the level of competition in local markets and thus by
local institutions and trade policies (see for instance Nocke and Yeaple (2008), Constinot (2004)).
Therefore, the previous regressions may not capture the e¤ects of contract enforcement costs and
intermediate tari¤s on the hold-up distortions in the vertical structure of …rms but rather their
e¤ects on …rm size. To ensure that this is not the case, I add the number of workers among
the regressors as a proxy for …rm size13 . It is reassuring to observe that the coe¢ cients on the
interaction terms are practically unchanged.
As already discussed, the ratio between value added and shipments is sensible not only to
the …rm’s vertical integration but also to the …rm’s market power. This would bias the results
if for example, trade barriers provide protection for monopolists or weak contract enforcement is
13
I have also experimented with regressions controlling for second, third and fourth order polinomial in …rm size
and found very similar results.
21
likely associated with weak antitrust policies. The use of country and industry …xed e¤ects should
alleviate the problem. As a further robustness check, in column 4, I have added a variable that
could eventually capture …rm’s market power: the market share for main product line. Again, the
main results are not a¤ected.
The quality of the judicial system and the openness to international trade are highly positively
correlated with the stage of development of a country. To exclude the possibility that CIc ASf and
T Bc ASf are merely serving as proxies for other factors associated with economic development, in
column 5 I add the interaction between per-capita GDP and asset speci…city among the regressors.
This addition does not alter the estimates on the two coe¢ cients of interest. It is interesting that
the coe¢ cient on this new regressor is negative and statistically signi…cant. Thus, when accounting
for tari¤s and contract enforcement, more machinery-intensive …rms tend to be relatively more
integrated in richer countries.
Finally, a potential concern regarding these regressions is prompted by multinational …rms
because they may choose their organizational structure independently from the business climate of
the country in which some of their activities are located. In the last two columns, I add a dummy
that identi…es …rms that are completely or partially owned by foreign parties. As expected, these
…rms are less vertically integrated; however, controlling for ownership does not a¤ect the estimates
for the coe¢ cients on the interaction terms.
In table 5, I replicate the estimates in the previous table using two alternative proxies for the
quality of contract-enforcing institutions: the number of procedures and the time that is necessary
to solve a commercial dispute in courts. From a qualitative perspective, the results are similar
to the previous ones. Reducing input tari¤s by one percentage point produces the same e¤ects on
the vertical structure of …rms as reducing the number of procedures by 1.4 or alternatively the
number of days necessary to solve the dispute by 7.5. These results are practically una¤ected when
controlling for the size of the …rms, their domestic market share and their ownership.
A large body of literature has emphasized the role of …nancial intermediaries in shaping the
degree of vertical integration of …rms. The predictions from theoretical models are mixed. On one
side, well-functioning …nancial intermediaries should increase the number of potential entrepreneurs
and, by fostering entry, reduce the average size of …rms. Because smaller …rms are less likely
to produce inputs on their own, …nancial development should then reduce vertical integration.
22
Moreover, this e¤ect should be disproportionately larger in sectors that are more capital intensive
which usually rely more on external …nance. On the other side, however, the lack of …nancial
development may prevent …rms that would like to vertically integrate from doing so (see Acemoglu,
Johnson and Mitton (2009) or McMillan and Woodru¤ (1999)).
To test these two competing theories and, most importantly, to exclude the possibility that the
previous empirical results are not merely capturing the e¤ect of …nancial development on the vertical
structure of …rms, I add the interaction between machinery intensity and …nancial development to
the regressors in table 6. I use two measures of …nancial development: an index of the strength of
legal rights in the …nancial sectors and an index of the depth of credit information. Both the OLS
and IV estimates con…rm the previous results regarding the e¤ects of contract enforcement and
tari¤s on the vertical structure of …rms. Moreover, the IV estimates appear to validate the view
that imperfections in the …nancial markets prevent …rms that would prefer to vertically integrate to
do so: in the data, more developed …nancial markets increases the propensity of …rms to vertically
integrate, disproportionately more for …rms that are more capital intensive.
The most interesting prediction of the model is the idea that opening to international trade
is a means of disciplining domestic suppliers and thus reducing the need for vertical integration.
This e¤ect should be larger when opening to countries that are characterized by well-functioning
contract-enforcing institutions because this action enables domestic investors to …nd potential foreign partners that they can trust. This intuition is con…rmed by the data. In the …rst two columns
of Table 6, the average tari¤s on intermediates are computed, respectively, on imports from the
entire world and on imports from high-income OECD countries. The coe¢ cient on the interaction
term between tari¤s and asset speci…city increases by nearly one-fourth in the second column; this
result validates the view that reducing tari¤s toward countries with better institutions is more
e¤ective in attenuating hold-up distortions.
A possible concern with these results is that a country’s level of openness to international
trade may be correlated with omitted country characteristics that have di¤erential e¤ects on …rms
characterized by di¤erent levels of asset speci…city. To ensure that this is not the case, columns
3 and 4 of table 6 control for output tari¤s. The point estimates are only slightly a¤ected. As
can be observed, only tari¤s on intermediates have di¤erential e¤ects on machinery-intensive …rms,
whereas the e¤ect of tari¤s on output is not signi…cant from both an economic and a statistical
23
point of view. This is a reassuring result since it is a further validation of theories according to
which vertical integration is a response to hold-up distortions rather than being originated by a
collusive motive. For instance, in Mendi (2011) an upstream monopoly uses vertical integration
to discipline oligopolist downstream …rms. In this setting, tari¤s on output should increase the
monopoly pro…ts and the incentives to sustain collusion by vertical integration while tari¤s on
inputs should produce the opposite e¤ect.
Finally, the last two columns of the table report the e¤ect of trade barriers on the vertical
structure of …rms by separating countries according to whether the cost of enforcing a contract is
below or above the sample median. Opening up to trade is more e¤ective in counteracting hold-up
distortions in countries with more expensive contract enforcement.
In conclusion, both the OLS and IV estimates are consistent with the theoretical predictions of
the model regarding the e¤ect of the speci…city of assets on the vertical structure of the …rms that
owned them. The e¤ect of the asset speci…city of …rms on their likelihood to vertically integrate
is increasing according to the cost, time and number of procedures that are necessary to enforce
contracts and according to the tari¤s for the import of intermediate inputs. This result does
not change when controlling for potential confounding factors, such as the economic development,
…nancial development and trade openness of a country.
4
Conclusion
This paper investigates the cross-country determinants of vertical integration using a new …rm-level
cross-country dataset. In particular, it revisits the e¤ects of the interaction between the technology
intensity of …rms with some speci…c institutional features on the vertical integration decisions. This
focus is motivated by both theory and anecdotal evidence.
First, I develop a simple model, in the spirit of TCE theories, to study the e¤ects of contract
enforcement and international trade on the vertical structure of …rms. The model suggests that
technology intensity should have greater e¤ects on the vertical structure of …rms when combined
with low-quality contracting institutions and high trade barriers. The empirical results are consistent with these predictions and are robust to di¤erent econometric speci…cations and techniques.
I conclude that poor contract enforcement can distort the vertical structure of …rms in the
24
presence of speci…c assets. This distortion can have signi…cant welfare costs, especially in developing
economies. If improving home institutions is not feasible, then an equivalent solution is to open to
international trade. This solution would attenuate the hold-up distortions by disciplining domestic
suppliers and thus reducing the need for vertically integrated organizations.
25
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[32] Ornelas, E. and Turner, J. (2008), "Trade liberalization, outsourcing and the hold-up problem",
Journal of International Economics 74, pp. 225-241.
[33] Tucker, I. B. and Wilder, R. P. (1977), "Trends in vertical integration in the US manufacturing
sector", Journal of Industrial Economics 26, pp. 81-94.
[34] Whinston, M. (2003), "On the Transaction Costs Determinants of Vertical Integration", Journal of Law, Economics and Organizations 19, pp. 1-23
[35] Williamson, O. (1975), "Markets and Hierarchies: an Analysis and Antitrust Implications",
Free Press, New York.
[36] Williamson, O. (1985), "The Economic Institutions of Capitalism", Free Press, New York.
28
A
Derivations
We can rewrite the pro…t function as E
Proof of Lemma 1.
and E
O
2
= Q( ; ; I) + (1
) (I; t) for I
O
1
= Q( ; ; I) for I < I (t)
I (t).
The producer chooses investment in order to maximize this pro…t function. For I < I (t), the
pro…t function is E
O
1
= Q( ; ; I) and, by HP2, it is locally convex. Thus, if a local maximum
exists in this range, then it is de…ned by the FOC
1
(1
)
2
dQ( ; ;I)
dI
= 0, which can be rewritten as:
g 0 (I ( ; ))
1
0
.
For I
I (t), the pro…t function becomes E
O
2
= Q( ; ; I) + (1
) (I; t) and, by the HP2
and HP3 is locally convex. Thus, if a local maximum exists in this range, then it is de…ned by the
FOC
dQ( ; ;I)
dI
)d
+ (1
1
(I;t)
dI
(1
= 0, which can be rewritten as:
)
1
(
2
F ( g (I)
t)) g 0 (I
( ; ; t))
1
0
Notice that if I ( ; ) > I (t), there cannot be a local maximum for I < I (t) :In fact, the
function Q( ; ; I) is strictly increasing in I for I < I (t). Therefore, the pro…t function will have
a single local maximum in I = I
( ; ; t).
In sum: If I ( ; ) > I (t), the pro…t function has a unique local maximum in I = I
( ; ; t).
If I ( ; ) < I (t), the pro…t function can have at most two local maxima respectively in I ( ; )
and I
( ; ; t).
Proof of Proposition 2.
The producer will choose the level of investment that maximizes the
pro…t function de…ned by equation 7. Given Lemma 1, the pro…t function has at most two local maxima: E
O
1
( ; ) = Q( ; ; I ( ; )) and E
O
2
( ; ; t) = Q( ; ; I
( ; ; t))+(1
) (I
( ; ; t) ; t).
In order to prove that optimal investment under outsourcing is decreasing in trade barriers t, we
will consider three di¤erent cases:
1. E
O
1
( ; ) is the global maximum for every t. In this case the optimal investment is I ( ; )
and does not depend on trade barriers.
29
2. E
O
2
( ; ; t) is the global maximum for every t. In this case the optimal investment is
I
( ; ; t). Applying the implicit theorem function to equation 8, is possible to verify that
I
( ; ; t) is a strictly decreasing function of t.
3. E
O
1
( ; ) is the global maximum for some values of t while E
O
2
( ; ; t) is the global max-
imum for some others. Notice while the …rst one is not a¤ected by t, the second one is
decreasing and continuos in t. Therefore, in this case it exists a unique b
t at which the producer is indi¤erent between I ( ; ) and I
E
O
1
( ; )
E
( ; ; t). This tari¤ is implicitly de…ned by:
; ;b
t : Consider an increase in trade costs dt. For t < b
t, the optimal in-
O
2
( ; ; t), which is decreasing in t. For t > b
t; the optimal investment is I ( ; ),
vestment is I
which is not a¤ected by t. Finally, when t increases from b
t dt to b
t + dt, the optimal investment drops from I
( ; ; t) to I ( ; ). Thus, also in this case investment is not decreasing
in t.
O
1
If the pro…t function has two local maxima E
Lemma 2.
( ; ) and E
O
2
( ; ; t), then it
should be that:
O
1
dE
( ; )
d
<
dE
O
2
( ; ; t)
d
Proof. Using the envelope theorem on equations 8 and 9:
dE
O
1
( ; )
d
dE
O
2
( ; ; t)
@E
=
d
O
2
( ; ; t)
=
@
=
@E
O
1
( ; )
@
=
P+
1
( ; ; t))
2
P + g(I
2
2
g(I ( ; ))
g(I Z(t; )) t
( g (I
( ; ; t))
t
pF ) dF pF
0
dE
De…ne
=
O(
2
; ;t)
d
2
(g(I
( ; ; t))
dE
O(
1
d
; )
. Using the two equations above, we get:
g(I ( ; ))
1
2
g(I Z(t; )) t
( g (I
( ; ; t))
t
pF ) dF pF
0
Given Lemma 1, the pro…t function can have two local maxima as long as I
30
( ; ; t) > I (t) >
I ( ; ). The fact that I
( ; ; t) > I (t) implies that:
g(I
2
(g(I
1
2
( ; ; t))
Z(
; ;t)) t
( g (I
( ; ; t))
t
pF ) dF pF
0
g (I(t)) t
>
2
Z
1
2
(g(I (t))
g I (t)
t
pF dF pF =
2
(g(I (t))
0
where the last equality comes from the de…nition of I (t). Finally, using the equation above
together with the fact that I (t) > I ( ; ), we get:
>
2
(g(I
( ; ; t))
g(I ( ; ))
Hence, if the pro…t function has two local maxima then
dE
O(
2
; ;t)
d
O
1
dE
O(
1
d
; )
<
.
Proof of Proposition 3.
E
> 0, which implies that:
Given Lemma 1, the pro…t function has at most two local maxima:
( ; ) = Q( ; ; I ( ; )) and E
O
2
( ; ; t) = Q( ; ; I
( ; ; t)) + (1
) (I
( ; ; t) ; t).
In order to prove that optimal investment is increasing in contract enforcement, we can divide our
analysis in three cases:
1. E
O
1
( ; ) is the global maximum for every : In this case the optimal investment is I ( ; )
for every . Applying the implicit theorem function to equation 9, is possible to verify that
I ( ; ) is a strictly increasing function of .
2. E
I
O
2
( ; ; t) is the global maximum for every
( ; ; t) for every . Applying the implicit theorem function to equation 8, is possible to
verify that I
3. E
. In this case the optimal investment is
O
1
( ; ; t) is a strictly increasing function of .
( ; ) is the global maximum for some values of
while E
O
2
( ; ; t) is the global max-
imum for some others.
De…ne
some
in
( ; ; t)
E
O
1
( ; )
E
O
2
( ; ; t). In this case
( ; ; t) takes positive values for
and negative values for others. Together with the fact that
(because sum of continuous function) and strictly decreasing in
31
( ; ; t) is continuous
(by claim 2), this
observation implies that there exists a unique b such that if
> b then
= b we have
( ; ; t) < 0 and for
O
1
the global maximum is E
O
1
( ; ; t) > 0, if
( ; b; t) = 0. In other words, if
> b global maximum is E
( ; ), if
the pro…t function has two global maxima E
O
2
( ; b) = E
O
2
( ; ; t) and if
the optimal investment is I
<b
= b,
( ; b; t). Consider an increase
< b, the optimal investment is I ( ; ) and hence is increasing in ; for
in . For
from b
< b then
( ; ; t) and hence is increasing in . Finally when
d to b + d , the optimal investment jumps up from I ( ; ) to I
> b,
increases
( ; ; t): thus
also in this case the optimal investment in increasing in .
Given Lemma 1 the pro…t function has at most two local maxima:
Proof of Proposition 4.
E
O
1
O
2
( ; ) and E
O
1
1. E
( ; ; t) for every . Three subcases are possible:
( ; ) is the global maximum for every . In this case the optimal investment is I ( ; )
for every . Applying the implicit theorem function to equation 9, is possible to verify that
I ( ; ) is a continuous and strictly decreasing function of .
O
2
2. E
( ; ; t) is the global maximum for every
. In this case the optimal investment is
I ( ; ; t) for every . Applying the implicit theorem function to equation 8, is possible to
verify that I
O
1
3. E
( ; ; t) is a continuous and strictly decreasing function of .
( ; ) is the global maximum for some values of
while E
O
2
( ; ; t) is the global
maximum for some others.
Consider
( ; ; t)
values for some
in
E
( ; )
E
O
2
( ; ; t) and notice that, in this case, it takes positive
and negative for others. Together with the fact that
(because sum of continuous function) and strictly increasing in
(1
) 12 [g(I ( ; ))
b such that if
b; ; t
O
1
is I
b;
g(I
< b then
=E
O
2
O
1
( ; ; t) is continuous
(notice that:
d ( ; ;t)
d
=
( ; ; t)]), this observation implies that there exists a unique
( ; ; t) < 0, if
= 0. In other words, if
global maximum is E
E
O
1
( ; ) and if
> b then
( ; ; t) > 0 and for
< b the global maximum is E
O
2
( ; ; t), if
= b,
> b
= b , the pro…t function has two global maxima
b; ; t . Consider an increase in . For
( ; ; t) and hence is decreasing in ; for
32
< b, the optimal investment
> b, the optimal investment is I ( ; ) and
hence is decreasing in . Finally when
jumps down from I
increases from b d to b +d , the optimal investment
( ; ; t) to I ( ; ): thus also in this case the optimal investment in
decreasing in .
33
B
Data sources and construction
B.1
Industry
Each ICA survey reports the industry of the …rms in the sample according to a di¤erent classi…cation
system and it is not clear what are the criteria used to choose a particular classi…cation system
over a di¤erent one. I have used the UN correspondence tables to convert all the industries into
ISIC Rev 3.1 or NACE Rev 1.1.14
B.2
Value of Output
The ICA surveys collects information on "Total market value of the production" (c274c1y) and
"Total sales" (c274a1y) but there is a high number of missing values. Therefore I have used the
following strategy:
Compute the number of observations about the value of the production and the total sales in
each country.
Generate the variable output which, in each country, equals the value of the production when
the number of observations about the value of production is at least 125 percent the number of
observations about total sales. Otherwise it equals the total sales.
Notice that I could have also adjusted total sales by subtracting the variation in the variable
"Inventories and stock" (281k1y). The problem is that inventories data are questionable: too many
…rms report zero while for Brazil and Ethiopia, when output is computed in this way, it is mostly
negative.
B.3
Cost of Intermediate Goods
I consider two di¤erent measures of raw material costs: "Raw material costs (excluding fuel)"
(c274b1y) and "Total purchase of raw material (excluding fuel)" (c274d1y). I use the former
variable when available and the latter otherwise.
The cost of energy is computed by summing up the variables "Consumption of electricity"
(c274f1y) and "Consumption of fuel" (c274g1y) when both are available and using the variable
14
The correspondence tables used for creating the dataset for this paper can be downloaded at:
http://unstats.un.org/unsd/cr/registry/regot.asp.
34
"Consumption of energy" (c274e1y) otherwise. For the remaining missing values, I impute the
share of energy in each sector over the raw material cost.
Finally I compute the cost of intermediate production goods by summing up the cost of material
and the cost of energy.
B.4
Vertical integration
Vertical integration is measured by the ratio of value added to sales (e.g.: (Total Output- Cost of
intermediate)/Total output). This measure has been used in many previous studies but, as already
discussed above, is susceptible to bias. This bias increases with the amount of value added by downstream …rms. For this reason my analysis is limited to …rms producing primarily in manufacturing
industries. The observations in the …rst and the last percentile have been dropped in order to
correct for outliers.
B.5
Number of workers
The ICA survey collects information on "Average number of permanent workers" (c262a1y) and
"Average number of temporary workers" (c263a1y). It is not clear whether missing values for
temporary workers indicate that there are no temporary workers in that …rm or that the respondent
simply gives the total number of workers under the voice permanent workers. I choose to totally
disregard data about temporary workers and consider permanent workers as the only measure of
the labor used in the production process. No information on hours per worker are collected. The
observations in the …rst and the last percentile have been dropped.
35
Table 2: Descriptive statistics per country
Country
Albania
Angola
Argentina
Armenia
Azerbaijan
Belarus
Bhutan
Bolivia
Bosnia and Herzegovina
Botswana
Brazil
Bulgaria
Burkina Faso
Burundi
Cameroon
Cape Verde
Chile
Colombia
Congo, Dem. Rep.
Costa Rica
Croatia
Czech Republic
Cote d’Ivoire
Ecuador
El Salvador
Estonia
Gambia
Georgia
Ghana
Guatemala
Guinea
Guinea-Bissau
Honduras
Hungary
Indonesia
Kazakhstan
Kosovo
Kyrgyz Republic
Laos
Latvia
Lebanon
GDP
6433
3838
11148
5645
10951
14241
4571
3781
6328
10072
10521
11083
962
389
1970
3344
11288
7394
249
9949
15971
25553
1491
6227
5835
18194
1205
4549
1292
5945
902
801
3489
18001
4381
13032
9444
2064
2621
13205
10481
Obs
37
194
407
56
82
52
90
191
143
98
966
615
80
90
166
51
990
492
142
245
380
47
83
254
452
79
30
156
277
162
131
41
125
78
612
116
56
127
409
147
110
Country
GDP
Obs
Lithuania
Macedonia
Madagascar
Malawi
Mauritania
Mauritius
Mexico
Moldova
Mongolia
Montenegro
Mozambique
Namibia
Nepal
Nicaragua
Niger
Oman
Panama
Paraguay
Peru
Philippines
Poland
Romania
Russia
Rwanda
Senegal
Serbia
Slovak Republic
Slovenia
South Africa
Swaziland
Tajikistan
Tanzania
Thailand
Timor-Leste
Turkey
Uganda
Ukraine
Uruguay
Uzbekistan
Vietnam
13963
8664
810
644
1781
9133
12922
2422
3798
8026
775
5148
1316
2116
545
14194
8494
3784
6818
3216
13714
9024
15704
956
1565
9444
21414
28131
7220
3489
1671
1007
6820
1293
10447
1063
7343
9562
2027
2973
188
53
238
70
76
204
675
135
115
22
298
92
130
185
27
38
105
127
231
439
716
381
320
52
253
102
42
82
1136
60
217
239
1172
30
1019
283
413
163
160
826
GDP is per-capita PPP converted GDP in 2005 at current prices (in International Dollars). Obs is the number of
…rms included in the sample.
36
37
Industry level data
Fixed Assets/Sales
Fixed + Intangible Assets/Sales
Fixed Assets /Assets
Fixed Assets + Intangible Assets/Assets
Fixed Assets/Workers
Fixed Assets + Intangible Assets/Workers
0.86
1.28
0.27
0.41
151.80
210.52
4.15
4.40
4.19
38.41
37.80
600.37
4.92
2.87
15,688
Country level data
Enforcing contracts: costs
Enforcing contracts: procedures
Enforcing contracts: days
Legal Right Index
Credit Information Index
GDP per capita (PPP, I$)
Country-industry level data
Tari¤s on intermediates
Tari¤s on intermediates (HI OECD)
Tari¤s on …nal goods
0.58
0.22
127.86
18.18
10.61
Firm level data
Value added/Sales
Machinery and equipment/Sales
Number of workers
Market Share
Foreign ownership (%)
Mean
2.32
2.47
0.13
0.12
1,117.41
1,146.61
2.83
3.05
3.01
29.84
5.92
290.99
2.19
2.04
37,704
0.22
0.23
429.24
11.73
28.66
St.Dev
0.26
0.44
0.17
0.34
37.49
74.77
2.14
2.25
2.03
21.25
33.00
405.00
3.00
1.00
1,122
0.42
0.05
11.00
9.53
0
25th Pctile
Table 3: Descriptive statistics
0.38
0.78
0.23
0.39
53.24
102.21
3.53
3.81
3.54
29.97
38.00
547.14
5.00
3.00
2,987
0.60
0.14
30.00
16.33
0
50th Pctile
0.68
1.10
0.35
0.46
80.10
157.29
5.66
6.15
5.88
41.70
41.00
745.00
6.67
5.00
9,022
0.77
0.32
96.50
23.39
0
75th Pctile
402
402
402
402
402
402
7,409
7,409
7,409
82
82
82
82
82
82
20,216
20,216
20,088
18,929
19,741
N
Table 4: Main Results
(1 )
(2 )
(3 )
OLS
2SLS
2SLS
D e p e n d e nt va ria b le is: Va lu e A d d e d / To ta l P ro d u c tio n (V I)
0 .0 2 1 9
(0 .0 1 5 2 )
AS
(4 )
2SLS
(5 )
2SLS
(6 )
2SLS
(7 )
2SLS
AS
TB
0 .0 0 4 5 6 *
(0 .0 0 2 4 4 )
0 .0 2 2 2 * *
(0 .0 1 1 0 )
0 .0 2 3 3 * *
(0 .0 1 0 8 )
0 .0 2 0 3 *
(0 .0 1 1 6 )
0 .0 2 3 7 * *
(0 .0 1 1 4 )
0 .0 2 2 2 * *
(0 .0 1 1 0 )
0 .0 2 2 3 * *
(0 .0 1 1 0 )
AS
CI
0 .0 0 0 3 6 0 *
(0 .0 0 0 2 0 4 )
0 .0 0 7 1 8 * *
(0 .0 0 2 9 9 )
0 .0 0 7 1 6 * *
(0 .0 0 3 0 4 )
0 .0 0 7 1 8 * *
(0 .0 0 2 9 1 )
0 .0 0 7 9 1 * * *
(0 .0 0 2 9 8 )
0 .0 0 7 1 8 * *
(0 .0 0 2 9 9 )
0 .0 0 7 2 4 * *
(0 .0 0 2 9 8 )
# Wo rke rs
-0 .0 1 1 2 * * *
(0 .0 0 3 0 4 )
M a rke t S h a re
AS
0 .0 0 1 5 7 * *
(0 .0 0 0 7 6 6 )
-0 .2 6 4 * *
(0 .1 1 0 )
GDP
Fo re ig n (>1 % )
-0 .0 1 0 6 * *
(0 .0 0 4 7 5 )
Fo re ig n (1 0 0 % )
IN D U S T RY D U M
C O U N T RY D U M
YEAR DUM
sa rg a n p
N
r2
F
YES
YES
YES
20231
0 .2 6 8
YES
YES
YES
0 .1 9 4
20216
YES
YES
YES
0 .1 9 5
20088
YES
YES
YES
0 .2 8 1
18929
YES
YES
YES
0 .1 9 6
20216
YES
YES
YES
0 .2 0 0
20216
-0 .0 1 2 7 *
(0 .0 0 7 4 6 )
YES
YES
YES
0 .1 9 8
20216
1 7 .8 8
1 8 .0 6
3 1 .0 4
1 8 .3 8
1 7 .8 2
1 7 .8 5
The table reports OLS and 2SLS estimates for the years 2003-2009. The unit of observation is the …rm. The left
hand side variable VI is the ratio of the value added produced by the …rm to the total sales. AS is the ratio of the
value of machinery and equipment to the total sales. Size is the number of workers in the plant. TB is average
tari¤s on intermediate inputs in the 4-digit ISIC industry code in the country where the plant is located. CI is the
cost to resolve a commercial dispute in courts on a claim equivalent to 200 percent of the average income of the
country. GDP is per-capita Gross Domestic Product at PPP international prices (in thousands international dollars).
Sarganp reports the p-value of the Hansen-Sargan overidenti…cation test. F is the F statistics for weak identi…cation.
Standard errors (robust and clustered at the level of the industry) are reported in parentheses. *** signi…cant at less
than 1 percent; ** signi…cant at 5 percent; * signi…cant at 10 percent.
38
Table 5: Alternative measures of contract enforcement
(1)
2SLS
(2)
2SLS
(3)
(4)
(5)
(6)
(7)
2SLS
2SLS
2SLS
2SLS
2SLS
Dependent variable is: Value Added/Total Production (V I)
AS T B
0.0110**
(0.00513)
0.0111**
(0.00524)
0.00990*
(0.00531)
0.0110**
(0.00513)
AS CI2
0.00784*
(0.00415)
0.00861**
(0.00421)
0.00802**
(0.00403)
0.00790*
(0.00417)
AS CI3
# Workers
0.0119**
(0.00493)
0.0102**
(0.00504)
0.0115**
(0.00486)
0.000324*
(0.000176)
0.000344**
(0.000174)
0.000355**
(0.000179)
0.0003427*
(0.000177)
-0.0115***
(0.00333)
0.00154**
(0.000781)
Foreign (100%)
INDUSTRY DUM
COUNTRY DUM
YEAR DUM
sarganp
N
r2
F
0.0114**
(0.00486)
-0.0115***
(0.00346)
Market Share
(8)
2SLS
0.00151*
(0.000805)
YES
YES
YES
0.161
20216
YES
YES
YES
0.188
20088
0.228
18929
-0.0119
(0.00798)
YES
YES
YES
0.167
20216
18.10
18.05
15.13
18.31
YES
YES
YES
0.134
20216
YES
YES
YES
0.153
20088
YES
YES
YES
0.198
18929
-0.0135*
(0.00744)
YES
YES
YES
0.138
20216
14.78
14.65
14.91
15.01
The table reports OLS and 2SLS estimates for the years 2003-2009. The unit of observation is the …rm. The left hand
side variable VI is the ratio of the value added produced by the …rm to the total sales. AS is the ratio of the value of
machinery and equipment to the total sales. TB is average tari¤s on intermediate inputs in the 4-digit ISIC industry
code in the country where the plant is located. CI2 and CI3 are respectively the number of procedures and the time
(in days) to resolve a commercial dispute in courts on a claim equivalent to 200 percent of the average income of
the country. Sarganp reports the p-value of the Hansen-Sargan overidenti…cation test. F is the F statistics for weak
identi…cation. Standard errors (robust and clustered at the level of the industry) are reported in parentheses. ***
signi…cant at less than 1 percent; ** signi…cant at 5 percent; * signi…cant at 10 percent.
39
Table 6: Robustness Checks: Adding Financial Development
(1)
(2)
(3)
(4)
(5)
2SLS
2SLS
2SLS
2SLS
2SLS
Dependent variable is: Value Added/Total Production (V I)
(6)
2SLS
AS
AS T B
0.0240**
(0.0122)
0.0257**
(0.0122)
0.0217*
(0.0128)
0.0243**
(0.0122)
0.0242**
(0.0121)
0.0250**
(0.0121)
AS CI
0.00668**
(0.00270)
0.00651**
(0.00270)
0.00677**
(0.00266)
0.00672**
(0.00269)
0.00668**
(0.00270)
0.00716**
(0.00304)
AS F D
-0.0547**
(0.0267)
-0.0559**
(0.0272)
-0.0533**
(0.0272)
-0.0515**
(0.0255)
-0.0554**
(0.0266)
-0.0461**
(0.0226)
AS F D2
# Workers
-0.0124***
(0.00318)
Market Share
(0.0272)
(0.000833)
AS GDP
INDUSTRY DUM
COUNTRY DUM
YEAR DUM
sarganp
N
F
YES
YES
YES
0.149
20216
15.52
YES
YES
YES
0.144
20088
15.42
YES
YES
YES
0.198
18929
33.29
-0.378
(0.208)
YES
YES
YES
0.148
20216
15.63
YES
YES
YES
0.156
20216
15.51
YES
YES
YES
0.150
20216
11.20
The table reports 2SLS estimates for the years 2003-2009. The unit of observation is the …rm. The left hand side
variable VI is the ratio of the value added produced by the …rm to the total sales. AS is the ratio of the value of
machinery and equipment to the total sales. TB is average tari¤s on intermediate inputs in the 4-digit ISIC industry
code in the country where the plant is located. CI is the cost to resolve a commercial dispute in courts on a claim
equivalent to 200 percent of the average income of the country. FD and FD2 are respectively an index of the strength
of legal rights and an index on the depth of …nancial information of the country. GDP is per-capita Gross Domestic
Product at PPP international prices. Sarganp reports the p-value of the Hansen-Sargan overidenti…cation test. F
is the F statistics for weak identi…cation. Standard errors (robust and clustered at the level of the industry) are
reported in parentheses. *** signi…cant at less than 1 percent; ** signi…cant at 5 percent; * signi…cant at 10 percent.
40
Table 7: Alternative measures of trade openness
AS CI
AS T B
(1)
(2)
(3)
(4)
(5)
2SLS
2SLS
2SLS
2SLS
2SLS
Dependent variable is: Value Added/Total Production (V I)
0.00718**
0.00678**
0.00879**
0.00792**
(0.00299)
(0.00288)
(0.00354)
(0.00326)
0.0222**
(0.0110)
0.0194*
(0.0118)
0.0272***
(0.00944)
AS T B2
AS T Bout
INDUSTRY DUM
COUNTRY DUM
YEAR DUM
sarganp
N
F
YES
YES
YES
0.194
20216
17.88
YES
YES
YES
0.186
20216
17.69
(6)
2SLS
0.0115**
(0.00516)
0.0280***
(0.0102)
YES
YES
YES
0.183
8972
52.79
YES
YES
YES
0.797
10805
19.31
0.0286**
(0.0142)
0.000183
(0.00406)
YES
YES
YES
0.373
18754
25.82
-0.00248
(0.00372)
YES
YES
YES
0.303
18754
25.47
The table reports 2SLS estimates for the years 2003-2009. The unit of observation is the …rm. The left hand side
variable VI is the ratio of the value added produced by the …rm to the total sales. AS is the ratio of the value of
machinery and equipment to the total sales. TB is average tari¤s on intermediate inputs in the 4-digit ISIC industry
code in the country where the plant is located. TB2 is average tari¤s on intermediate inputs imported from highincome OECD countries. TBout is average tari¤s on …nal goods. CI is the cost to resolve a commercial dispute in
courts on a claim equivalent to 200 percent of the average income of the country. Sarganp reports the p-value of
the Hansen-Sargan overidenti…cation test. F is the F statistics for weak identi…cation. Standard errors (robust and
clustered at the level of the industry) are reported in parentheses. *** signi…cant at less than 1 percent; ** signi…cant
at 5 percent; * signi…cant at 10 percent.
41
Figure 2: The central line depicts the estimated marginal e¤ect of vertical integration (measured
as the ratio of value added to total sales) on asset speci…city (measured as the ratio of the value
of machinery and equipment to total sales). The other two lines de…ne the 5 percent con…dence
boundaries.
42