Vertical integration in China

In economics vertical integration is normally thought about in terms of providing incentives, protecting relationship-specific investments, dealing with hold-up problems or reducing transaction costs etc. But a new NBER working paper has another story. Joseph Fan, Jun Huang, Randall Morck, and Bernard Yeung have a paper on Vertical Integration, Institutional Determinants and Impact: Evidence from China. They show that vertical integration in highly interventionist environments, like those in China, may be aimed not at the issues noted above, but at rent-seeking and the pursuit of other forms of political privilege. Their abstract reads:

Where legal systems and market forces enforce contracts inadequately, vertical integration can circumvent these transaction difficulties. But, such environments often also feature highly interventionist government, and even corruption. Vertical integration might then enhance returns to political rent-seeking aimed at securing and extending market power. Thus, where political rent seeking is minimal, vertical integration should add to firm value and economy performance; but where political rent seeking is substantial, firm value might rise as economy performance decays. China offers a suitable background for empirical examination of these issues because her legal and market institutions are generally weak, but nonetheless exhibit substantial province-level variation. Vertical integration is more common where legal institutions are weaker and where regional governments are of lower quality or more interventionist. In such provinces, firms led by insiders with political connections are more likely to be vertically integrated. Vertical integration is negatively associated with firm value if the top corporate insider is politically connected, but weakly positively associated with public share valuations if the politically connected firm is independently audited. Finally, provinces whose vertical integrated firms tend to have politically unconnected CEOs exhibit elevated per capita GDP growth, while provinces whose vertically integrated firms tend to have political insiders as CEOs exhibit depressed per capita GDP growth.

This result suggests another reason why highly interventionist governments can lead to economically inefficient outcomes. Firms grow for rent-seeking rather than efficiency reasons. This is one of a small number of papers that deals with the issue of how firms organise to take advantage of political processes and institutions. Public choice meets theory of the firm.