Vertical Integration and Relational Contracts: The Threat Point Effect

Abstract

Firms in low-income countries often face frictions sourcing inputs and rely on vertical integration or relational contracts rather than spot markets. Empirical evidence highlights that vertical integration and relational contracts co-exist both within industries and individual firms. What are the economic and policy implications of this co-existence? This paper identifies and quantifies a new mechanism that I call the threat point effect, which is the contract change from firms improving their bargaining position due to partial vertical integration. I build and estimate a structural model to quantify the threat point effect in the context of a large Indian garment manufacturer that adds integrated capacity bargaining with its relational fabric suppliers. Model estimation uses the universe of the manufacturer’s fabric purchase transaction data. The threat point effect reduces input prices by 6.7% for small constrained suppliers that highly value the reduced exposure to demand shocks in the relational contract. I analyze counterfactuals that i) increase downstream buyer competition and ii) create the missing market, specifically insurance against demand shocks, that leads small firms to offer discounts in the relational contract. Only the latter shifts surplus to small firms.