1996 Reports

Globalization' and Vertical Structure

McLaren, John

This paper analyzes the effects of international openness on vertical integration decisions. A simple model is presented to represent the asset specificity problem at the heart of many industrial organization economists’ analysis of vertical integration. It suggests that there is a kind of negative externality conferred by each vertical integration, by ‘thinning’ the market for inputs and thus worsening opportunism problems; thus, in equilibrium there tends to be too much of it. Further, vertical integration features a kind of strategic complementarity, which can lead to multiple equilibria in the outsourcing decision, thus providing a theory of different ‘industrial systems’ or ‘industrial cultures’ in ex ante identical countries. In addition, the country that gets stuck in a highly vertically integrated equilibrium suffers from lower efficiency. Greater international openness forces convergence in the degree of outsourcing across countries, and facilitates leaner, less integrated firms, thus providing a channel for welfare improvements from international openness that appears to be quite different from those that are familiar from the trade theory literature. This may be taken as one theory of ‘outsourcing,’ ‘downsizing’ and ‘Japanization’ as consequences of ‘globalization.’