15 Jul 2010Working Paper Summaries

Trade Policy and Firm Boundaries

by Laura Alfaro, Paola Conconi, Harald Fadinger and Andrew F. Newman

What is the impact of trade policies on firms' ownership structures? Drawing on analysis based on a unique database from Dun and Bradstreet that contains both listed and unlisted plant-level observations in more than 200 countries, HBS professor Laura Alfaro and coauthors describe a simple model in which firms' boundaries depend on the prices of the products they sell: The higher the prices, the more integrated firms will be. More generally, when equilibrium prices converge across economies, so do ownership structures. The reason behind these predictions is that integration, although more productive than non-integration because of its comparative advantage in the coordination of firms' operating decisions, also imposes higher private costs on enterprise managers. At low prices, the productivity gains from integrating have little value, and managers choose non-integration. As prices rise, the relative value of coordination increases, favoring integration. Key concepts include:

Results lend empirical support to a simple model of the determination of firm boundaries in a global economy.
There is systematic relationship between firm boundaries and the equilibrium price in the product market.
Higher prices, as proxied by higher most-favored-nation tariffs, lead to more vertical integration at the firm level. The impact of tariffs on vertical integration is significant.
Enterprises' integration choices affect not only their productivity, but also aggregate economic performance and consumer welfare.

Author Abstract

We study how trade policy affects firms' ownership structures. We embed an incomplete contracts model of vertical integration choices into a standard perfectly competitive international trade framework. Integration decisions are driven by a trade-off between the pecuniary benefits of coordinating production decisions and the managers' private benefits of operating in preferred ways. The price of output is a crucial determinant of this choice, since it affects the size of the pecuniary benefits: higher prices lead to more integration. Because tariffs increase domestic product prices, this effect provides a novel theoretical channel through which trade policy can influence firm boundaries. We then examine the evidence, using a unique dataset to construct firm-level indices of vertical integration for a large set of countries. In line with the predictions of our model, we obtain three main results. First, higher tariffs lead to higher levels of vertical integration at the firm level. Second, differences in ownership structure across countries, measured by the difference in sectoral vertical integration indices, are smaller in sectors with similar levels of protection. Finally, ownership structures are more alike among members of regional trade agreements.