Advanced Corporate Strategy

ST104x

Why do companies in emerging economies vertically integrate?

We will next discuss the special case of vertical integration in emerging economies. As we
discussed in the previous module on product diversification, emerging markets are
characterized by institutional voids. These institutional voids imply that capital markets,
product markets and labour markets do not work efficiently.

Further, governments play a much larger role in emerging economies, especially in regulation
and also contract enforcement tends to be weak. All these would imply that transaction costs
will be higher in emerging economies compared to developed economies where institutions
are well developed. Therefore, one should expect higher levels of vertical integration in
emerging economies.

There is some empirical evidence to corroborate this idea. Firms tend to vertically integrated
when contracting costs are high but only when financial development is high, or the industry
is subject to holdup risk. High vertical integration can create the need for vertical integration
but without financial development in the economy, firms may not have access to the
resources that are necessary for undertaking vertical integration.

What about trends over time?

Most emerging economies are developing stronger institutions over time and removing
institutional voids, thereby resulting in a decrease in contracting costs. Thus, we can expect
that levels of vertical integration in emerging economies will come down over time.

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