On synergies and vertical integration

We analyze in an incomplete contracts model whether a supplier should be in tegrated if in addition to his investment level he chooses the degree of re lationship specificity. A basic trade-off arises: While non-integration lea ds to higher investment incentives, potential synergies are foregone. Hence , integration can be optimal even though only the supplier makes an investm ent decision. This may also clarify the discussion on which activities belo ng to a firm's core competencies. Furthermore, we show that if specificity is contractible, less than the efficient degree of specificity will deliber ately be chosen since investment incentives are thereby improved. (C) 2001 Elsevier Science B.V. All rights reserved.