published in: Zeitschrift für Betriebswirtschaft, 2004, 74 (1), 27-52
The costs of vertical integration are analyzed within a game-theoretic signaling model. It is
shown that a company when being vertically integrated with a supplier may well decide to
buy certain components from this supplier even at a lower quality than that offered by
external sources. When the parent company decides to stop buying components from the
integrated supplier, the value of the ownership share in the supplier is reduced: On the one
hand, the supplier’s profit from the transactions with its parent is foregone. But on the other
hand, other clients may decide against buying from this supplier as the latter’s reputation for
providing an appropriate quality is damaged. The loss in value of the ownership share may
outweigh the loss due to the lower quality. The anticipation of this effect leads to reduced ex
ante incentives for the supplier’s management to raise quality. A spin-off may therefore be
beneficial as it strengthens incentives. Costs and benefits of vertical integration are analyzed
and consequences for vertically integrated companies organized in profit centers are
discussed.
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