Vertically integrating suppliers is a strategy firms use to improve product quality by ensuring higher-quality inputs

Access to wealthier, quality-sensitive markets brings rising returns to output quality. However, producing high quality outputs typically requires high quality inputs (e.g. Kugler and Verhoogen 2012, Halpern et al. 2015, Amodio and Martinez-Carrasco 2018). Input quality is often challenging for firms to measure and contract over – especially in developing countries, where institutions are weak. Consequently, a firm’s organisational structure may play an important role in its ability to meet demand for quality. 

In a forthcoming paper, we explore whether firms choose to change their organisational structure in order to overcome this contracting failure (Hansman et al. forthcoming). More precisely, we ask if firms vertically integrate to be able to produce higher quality products, an idea inspired by classical theories characterising how firm boundaries are expected to respond to output objectives when suppliers multitask (Coase 1937, Gibbons 2005, Lafontaine and Slade 2007).

The Peruvian fishmeal industry 

We study firms’ choice of organisational structure in the Peruvian fishmeal manufacturing industry. Fishmeal is a brown powder mostly used as livestock and aquaculture feed, which is obtained from burning or steaming fish. Manufacturers are spread throughout the Peruvian coast and obtain their main input (fish) from independent and vertically integrated suppliers (fishing boats). For several technological reasons, the quality of the input (fish freshness) is difficult to observe at the time of purchase, and therefore challenging to contract upon. 

The data we use are unusually rich. First, the regulatory authorities record all transactions between fishmeal plants and their integrated and independent suppliers. Second, firms are required to report their production of high and low-quality fishmeal each month; a direct measure of output quality. Third, the fishing boats are required to transmit hourly Global Positioning System (GPS) signals to the regulatory authorities while at sea. We – but not non-parent firms – can thus track the behaviour of both vertically integrated and independent suppliers. 

Vertical integration and output quality

Our study finds evidence that firms indeed use vertical integration as a strategy for increasing output quality. We first investigate how variation in the quality premium – the price differential between high- and low-quality fishmeal – affects firms’ integration decisions. To do this, we start from the observation that firms producing mostly high-quality output have little room to improve quality further, and hence have less of an incentive to make strategic responses to an increased quality premium than firms producing mostly low-quality output. 

Using exogenous variation in the quality premium caused by the regulatory fishing quotas of other countries that produce high quality fishmeal, we show that the Peruvian manufacturers integrate when their incentive to upgrade quality rises, and vice versa. The integration response is stronger for firms with more room for upgrading output quality. 

We also find that firms do not integrate suppliers when faced with higher average prices, indicating that general incentives to scale production up or down or income shocks cannot explain the integration response to variation in the quality premium.

Of course, firms likely have other motives for integrating suppliers as well, such as general supply assurance. However, it is difficult to see how these could explain the organisational response of Peruvian fishmeal manufacturers to variation in the quality premium. Our results thus suggest that quality upgrading itself is an important motive for integrating suppliers.

Integration as a strategy for increasing output quality

We show evidence that integration allows parent companies to incentivise quality-increasing supplier actions. Input quality is hard to measure, and other manufacturers may care less about quality. In the presence of such contracting challenges, suppliers tend to prioritise quantity over quality. For example, many fishing boats will stay long at sea or travel far from shore seeking to fill their capacity, which will tend to decrease fish freshness and therefore input quality.

Sometimes the only way for firms to ensure quality inputs is to bring a supplier inside the firm (Baker et al. 2001, 2002, Gibbons 2005a, 2005b). We use hourly GPS-based measures of supplier behaviour to compare two conditions of a given boat’s actions when delivering to a given plant: 

  1. when the two are independent entities, and 
  2. when the two are integrated.

Our results show that suppliers deliver lower total quantities, travel less far from shore, and spend less time at sea when they are integrated with the plant they deliver to. These actions are consistent with the delivery of fresher fish. We show that it appears to be integration itself – not repeated interactions – that influences boats’ quantity-versus-quality decisions. 

In the final part of our paper, we exploit variation in weather and other arbitrary factors that influence the locations of boats to show evidence suggesting that plants ultimately produce higher-quality outputs when sourcing a larger share of their inputs from vertically integrated suppliers.

Organisational structure and output objectives

Our study bridges and advances the literature on the boundaries of the firm and quality upgrading. Existing studies have explored how firms change their relative use of integrated suppliers in response to changes in, for example, available contracts or monitoring technology (Baker and Hubbard 2003, Breza and Liberman 2017). We instead study how firms change their organisational structure in response to changes in their output objectives. 

Our study provides some of the first direct evidence on how integration can alter suppliers’ quantity-quality trade-off and how vertical integration can affect downstream output quality. Since challenges in determining input quality and enforcing contracts are so common, we suspect that other industries producing vertically differentiated outputs may face similar motivations to vertically integrate as those found in the Peruvian fishmeal industry. The results of our study are likely especially relevant to developing countries where firms attempt to meet the growing global demand for quality. 

References

Amodio, F and M A Martinez-Carrasco (2018), “Input Allocation, Workforce Management and Productivity Spillovers: Evidence from Personnel Data”, Review of Economic Studies 85(4): 1937–1970.

Baker, G, R Gibbons and K J Murphy (2001), “Bringing the Market Inside the Firm?”, American Economic Review 91(2): 212–218.

Baker, G, R Gibbons and K J Murphy (2002), “Relational Contracts and the Theory of the Firm”, The Quarterly Journal of Economics 117(1): 39–84.

Baker, G and T Hubbard (2003), “Make Versus Buy in Trucking: Asset Ownership, Job Design and Information”, American Economic Review 93(3): 551–572.

Breza, E and A Liberman (2017), “Financial Contracting and Organizational Form: Evidence from the Regulation of Trade Credit”, Journal of Finance 72(1): 291–324.

Coase, R H (1937), “The Nature of the Firm”, Economica 4(16): 386–405.

Gibbons, R (2005a), “Four formal(izable) theories of the firm?”, Journal of Economic Behavior and Organization 58(2): 200 – 245.

Gibbons, R (2005b), “Incentives Between Firms (and Within)”, Management Science 51(1), 1–150.

Halpern, L, M Koren and A Szeidl (2015), “Imported Inputs and Productivity”, American Economic Review 105(12): 3660–3703.

Hansman, C, J Hjort, G León and M Teachout (forthcoming), “Vertical Integration, Supplier Behavior, and Quality Upgrading among Exporters”, Journal of Political Economy. 

Kugler, M and E Verhoogen (2012), “Prices, Plant Size, and Product Quality”, Review of Economic Studies 79(1): 307–339.

Lafontaine, F and Slade, M (2007), “Vertical Integration and Firm Boundaries: The Evidence”, Journal of Economic Literature 45(3): 629–685.

Peru Industry Quality Production Organisational structure Vertical integration