Contract Incompleteness, Globalization and Vertical Structure: an Empirical Analysis

Luigi Pascali (Boston College)

Abstract: This paper develops a simple methodology to study the determinants of vertical integration emphasized by the transaction cost theories with particular emphasis on contract incompleteness and trade barriers. The empirical analysis uses new data on manufacturing firms operating in 65 countries coming from the ICA World Bank Surveys. This dataset is combined with the World Bank Doing Business database which gives general informations on countries' trade barriers and justicial system and with the UNCTAD TRAINS database which contains informations on import tariffs. I find that: 1) consistent with transaction cost theories, higher contract enforcement costs and higher trade barriers increase the likelihood of vertical integration; 2) asset specificity have a positive effect on the likelihood of vertical integration only in the presence of trade barriers to intermediate goods. I conclude that poor contract enforcement can distort firms' vertical structure in the presence of specific assets. This can have significant welfare costs. If improving home institutions is not feasible an equivalent solution is to reduce the trade barriers to specific assets produced in countries with better contract enforcement.