Vertical Integration and Sunk Capital in Transition Economies

Agency problems in inter-firm trading relationships are severe in developing and transitional economies because of the limited decentralized information that can support contract enforcement and because the timing of intermediate goods production and payment differ. The consequences are derived for the equilibrium distribution of firm structures, production, prices, profits and trade in developing and transitional economies. Within a multi-market setting, equilibrium outcomes are characterized both for firms that are directly affected by contracting problems and for those that are not. The equilibrium features both excessive vertical integration and excessive development of small-scale retail enterprises, and insufficient, inefficient inter-firm trade. Average profits of vertically integrated firms are higher and those of small-scale retail enterprises and intermediate suppliers are lower than they would be were enduring trading relationships more easily established.