Product Variety and Vertical Integration

Abstract

In vertical relationships the potential for scale economy in manufacturing often calls for specialization and outsourcing. Specialization, however, depends critically on the stability of the task and contractual environment. In a highly uncertain environment the need for frequent mutual adjustments favors integration instead of outsourcing. To evaluate vertical relationships in value chains where one stage competes on product variety under great uncertainty and the other stage competes on scale, we compare operations data at about 300 distribution centers within a major soft-drink bottler before and after it was integrated into an upstream firm. We find that vertical integration improved coordination for the integrated firm by aligning incentives and reducing strategic information asymmetry, but it worsened coordination for upstream rivals who shared the same downstream facilities.