Does vertical integration increase product quality?∗
Sanxi Li
School of Economics, Renmin University of China
[email protected]
Xinyu Li
Department of Management, Paderborn University
[email protected]
Zhan Qu
Faculty of Business and Economics, TU Dresden
[email protected]
December 9, 2016
∗
We like to thank participants of TEAM seminar at Paderborn University for their useful suggestions
and feedback.
1
Abstract
Numerous product quality scandals are caused by low quality inputs. When downstream firms cannot perfectly observe the quality of their inputs, upstream firms have
moral hazard problems. If vertical integration does not eliminate the moral hazard
problems, do downstream firms still have incentives to integrate upstream firms to
improve product quality? We find that given the precision of the downstream firms’
monitoring, when the public monitoring level is very high or very low downstream
firms have no incentive to integrate; when the public monitoring level is medium
downstream firms have incentives to integrate. In addition, under vertical integration firms always produce high quality products.
JEL Classification: L15, L23, D86, D82
Keywords: vertical integration, product quality, asymmetric information
2
1
Introduction
There are numerous scandals of product quality in many industries. A lot of the scandals
are caused by low quality inputs from upstream firms. For instance, in 2008 Chinese milk
scandal upstream suppliers adulterated raw milk with melamine which ruined the product
quality of downstream processors; in 2014 a supplier to McDonald’s and KFC in China
was accused of providing expired beef and chicken which damaged the reputation of the
downstream firms. When downstream firms cannot perfectly observe the true quality of
the inputs, the upstream firms may provide low qality inputs to cheat the downstream
firms.
After those scandals, downstream firms take different approaches to control their input
quality. Some milk processors decided to integrate upstream suppliers for a better control
of the input quality and emphasized how important vertical integration is to control quality. However, the other processors did not integrate any upstream suppliers. Similarly,
McDonald’s and KFC just switched to another upstream supplier rather than integrating
one. For an industry, why do some firms integrate upstream firms and the others not?
For an international firm, why does it integrate upstream firms in a country but not in
another? The relationship between vertical integration and product quality is a key to
these questions.
In this paper we aim to understand in which condition a downstream firm would like
to integrate an upstream firm via a theoretical investigation. In addition, we address the
relationship between vertical integration and product quality.
In our model a downstream firm (D) buys inputs from an upstream firm (U ) to produce
final products. The final product quality is determined by the input quality. U can produce
a low quality input at no cost and a high quality input at a positive cost. D cannot observe
the input quality directly but through a test. When the input quality is high, the test is
3
always correct; when the input quality is low, the test shows a wrong result with a small
probability. Similarly, consumers do not observe the product quality directly but through a
test conducted by a public agency. The public agency also has a small probability to make
a mistake when the product quality is low and no mistake when the product quality is
high. We assume that vertical integration does not reveal the input quality to D but gives
it a freedom to write any contract with U . Given that U has a positive outside option for
inputs that are tested as low quality by D, without vertical integration D can only decides
how much to pay for inputs tested as high quality. However, under vertical integration, D
can additionally specify a price different with the outside option for inputs tested as low
quality.
In a nutshell, we find a high and a low cut-off value for the public test precision. Given
the outside option and D’s test precision, when the public test precision is beyond the high
cut-off value, D will induce U to produce high quality products and has no incentive to
integrate U ; when the public test precision is below the low cut-off value, D will induce U
to produce low quality products and also has no incentive to integrate U ; when the public
test precision is in between, D will integrate U to produce high quality products. Given the
outside option and a low public test precision, D may switch from producing low quality
products without integration to producing high quality products with integration when it
increases its test precision. The finding implies that for an industry, a firm integrates an
upstream firm when its test precision is high and does not integrate when its test precision
is low; for a international firm, it may integrate in a country where the public test precision
is in the middle and may not integrate in a country where the public test precision is too
low or too high.
The remaining of the paper is organized as follows. We shortly discuss the related
literature in the next section. Then we present our model in Section 3. In Section 4 we
discuss the implication of the model and conclude.
4
2
Literature review
To discuss the relationship between vertical integration and product quality, we first need
to understand what vertical integration brings to the involved parties. There are two
approaches to look at what vertical integration brings in literature.
The first approach assumes that vertical integration bring the missed information to
the uninformed party. Since two parties have the same information, the moral hazard
problem is solved by integration. This assumption makes sense when vertical integration
makes it easy for the uninformed party to monitor the informed party’s action. Vetter
and Karantininis (2002) assume that under vertical integration the upstream firm has no
incentive or is unable to cheat the downstream firm while it is cheating the downstream firm
under non-integration. Hennessy (1996) also assumes that vertical integration removes the
need to test the product quality from the upstream firm. Hence, the moral hazard problem
disappears. Similarly, Lu et al. (2012) assume that in the case of vertical integration
the downstream firm just replaces the upstream firm to make the decision about quality
provision that is the decision of the upstream firm under non-integration. To sum up, in this
strand of literature the asymmetric information problem is solved by vertical integration
because the uninformed party becomes informed under integration. Under this approach,
if inducing the upstream firm to produce high quality inputs is the aim of the uninformed
downstream firm, vertical integration will lead to high quality products.
The second approach assumes that vertical integration does not bring any new information but changes the bargaining power of each party when they disagree who should get
what. The key assumption of this approach is that action is observable to two involved
parties but not verifiable to a third party. Vertical integration changes the ownership of a
property hence changes the bargaining power of each party. Under vertical integration, two
parties will still dispute on the true quality of product from the upstream firm. However,
5
since vertical integration changes the bargaining power of each party, the upstream firm
faces a different incentive to invest in product quality compared to under non-integration.
Hart et al. (1997) and Hart (2003) use this approach to discuss when a government should
outsource a service provision.
Our paper is different from the above two approaches but represents some features of
them. We assume that two parties have different information about the input quality and
vertical integration does not eliminate asymmetric information. Without integration, the
contract offered by the uninformed party is restricted by the outside option of the informed
party. But with integration, the uninformed party has a bigger contract space than before.
Hence, vertical integration changes the upstream firm’s incentive to provide high quality
inputs, which makes it possible that vertical integration increase product quality.
3
The model
We investigate whether vertical integration increases product quality. We assume that
a downstream firm (D) buys inputs from an upstream firm (U ). D has a one-to-one
production technology which implies that the final product quality is fully determined by
the input quality. U can produce a low quality input (L) at zero cost or a high quality
input (H) at a cost of C. It has an outside option S for the low quality input. Input
quality cannot be directly observed by D. However, D has a test technology which shows
H for sure when the input quality is high, and shows L with a probability of t ∈ (0, 1)
and H with a probability of 1 − t when the input quality is low. We call this test as a
private monitoring. Besides the private monitoring, there is a public agency which tests
the quality of the final product. The public agency has a test technology which shows H
for sure when the final product quality is high, and shows L with a probability of q ∈ (0, 1)
and H with a probability of 1 − t when the final product quality is low. Consumers pay
R for a product tested as H by the public agency and zero for a product tested as L. We
6
assume R > C.
In short, the game proceeds as follows.
1. Given the private monitoring t, D provides a take-it-or-leave-it offer to U , this offer
stipulates prices for inputs tested as high and low quality (PH , PL )
2. If U accepts this offer, D gets inputs according to the contract and turns the inputs
into final products then sell them to consumers.
3. Public agency tests the final products and informs consumers of the results.
4. Consumers make purchase decisions.
3.1
Benchmark: Non-integration
We first consider the situation where vertical integration is not available. When D decides
a contract, it can offer either a contract to induce high quality inputs or a contract to
induce low quality inputs. Given a contract (PH , PL ), U has the following payoff
(
PH − C
if U produces high quality inputs
πnu =
(1 − t)PH + tPL
if U produces low quality inputs
To induce U to produce high quality inputs, the following condition must be satisfied
PH − P L ≥
C
.
t
Since U has an outside option S for a low quality input, D will offer PL = S and PH = S+ Ct
to induce U to produce high quality inputs. Then the profits for D and U are
C
t
(1)
C
−C
t
(2)
h
πnd
= R − PH = R − S −
h
πnu
= PH − C = S +
To induce U to produce low quality inputs, D will offer PH = PL = S. Then the profits
for D and U are
l
πnd
= (1 − q) R − S
(3)
7
l
=S
πnu
(4)
D compares its profit for inducing high quality inputs with the profit for inducing low
quality inputs to decide which contract to offer. We see
h
l
πnd
≥ πnd
⇐⇒ q ≥
Denote
C
tR
C
.
tR
by qn∗ , then we have
Proposition 1. Under non-integration, there is a cutoff value of the public monitoring
qn∗ =
C
.
tR
If q > qn∗ , high quality products are produced; otherwise, low quality products are
produced.
3.2
Integration
Now we consider the situation where vertical integration is available. Vertical integration
has two crucial implications in our model. First, vertical integration does not solve the
moral hazard problem. After integration, downstream firms still cannot perfectly observe
the quality of inputs. Given the imperfect monitoring, moral hazard problems do not
disappear. Second, vertical integration gives D a right to deal with inputs produced by U .
Specially, D can set any price for a low quality input after integration.
When vertical integration is available, the first stage of the game we described before
changes to
1. Given the private monitoring t, D provides a take-it-or-leave-it offer to U , this offer
stipulates vertical integration (I = 1) or not (I = 0) and prices for inputs tested as
high and low quality (PH , PL ).
and the rest remains as before. The benchmark is the case of I = 0. In the following,
we investigate what the contract (PH , PL ) looks like in the case of I = 1. There are two
scenarios.
8
3.2.1
When q > qn∗
U must not earn less than before to accept the integration offer. When q > qn∗ , U earns
h
πnu
=S+
C
t
− C under non-integration. The condition for inducing high quality inputs
is PH − PL ≥
PH = S +
C
.
t
C
.
t
To induce high quality inputs, D can offer PL = 0 but at least offer
To induce low quality inputs, it offers a contract PH = PL = S +
C
t
− C.
Then the profits for D are
h
πid
= R − PH = R − S −
C
t
l
πid
= (1 − q)R − PL = (1 − q)R − S −
(5)
C
+C
t
(6)
h
l
Comparing the profits, we know πid
≥ πid
. Hence D will offer a contract to induce high
quality inputs. However, under integration with this contract it earns the same profit as
under non-integration.
Lemma 1. When q > qn∗ , D does not have incentives to integrate U .
This result illustrates that when the public monitoring level is very high, firms already
employ proper contracts to induce high quality inputs and there is no room to benefit from
vertical integration.
3.2.2
When q < qn∗
Similarly, U must not earn less than before to accept the integration offer. When q < qn∗ ,
l
U earns πnu
= S. The condition for inducing high quality inputs is PH − PL ≥
C
.
t
To
induce high quality inputs, D sets PL = 0 and PH = max{ Ct , S +C}. To induce low quality
inputs, it offers PH = PL = S .
The profit for D is
C
h
πid
= R − max{ , S + C}
t
(7)
l
= (1 − q) R − S
πid
(8)
9
Comparing D0 s profits, we have
1 S
C
h
l
πid
≥ πid
⇐⇒ q ≥ max{ − , 1} .
t C
R
We denote max{ 1t − CS , 1} CR by qi∗ . Notice that qi∗ = max{ 1t − CS , 1} CR ≤
1C
tR
= qn∗ . Under
integration D will offer a contract to induce high quality inputs when the public monitoring
level is higher than qi∗ . Otherwise, it will offer a contract to induce low quality inputs.
q=1
qn∗ =
1C
tR
qi∗ = max{ 1t − CS , 1} CR
q=0
Figure 1: Illustration of Proposition 2
Proposition 2. When the public monitoring q ∈ [qi∗ , qn∗ ], D will integrate U to produce
high quality products; when q > qn∗ , D will produce high quality products but does not benefit
from integrating U ; when q < qi∗ , D will produce low quality products but does not benefit
from integrating U .
Fix private monitoring t and outside option S. When we increase public monitoring q,
D will switch from low quality products to high quality products. D definitely integrates
U if q is moderate but does not necessarily integrate if it is very high. This result explains
why an international firm may integrate in a country but not in another.
Fix q and and S. When we increase t, D may start to integrate U to produce high
quality products. This result explains why in an industry some firms vertically integrates
but the others not.
10
4
Conclusion
This paper investigates the relationship between vertical integration and product quality.
Under the assumption that vertical integration does not eliminate moral hazard problems,
we provide conditions that vertical integration still can improve product quality. This
improvement comes from that downstream firms have a larger contract space compared
to the non-integration situation. When the upstream firm’s outside option of low quality
input is positive, there is room for the downstream firm to to enlarge contract space via
integration.
Under above assumptions, we find that there exist two cut-off values of the public monitoring. When the public monitoring level is in between, downstream firms have incentives
to integrate upstream firms to produce high quality products. When the public monitoring
level is higher than the high cut-off value, downstream firms have no incentive to integrate
but still produce high quality products. When the public monitoring level is lower than
the low cut-off value, downstream firms have no incentive to integrate and produce low
quality products.
References
1. Hart O, A Shleifer, and RW Vishny (1997). The Proper Scope of Government:
Theory and an Application to Prisons. The Quarterly Journal of Economics 112 (4):
1127-1161.
2. Hart O (2003). Incomplete Contracts and Public Ownership: Remarks, and an
Application to Public-Private Partnerships. The Economic Journal 113: C69-C76.
3. Hennessy, D (1996). Information Asymmetry as a Reason for Food Industry Vertical
Integration. American Journal of Agricultural Economics 78(4): 1034-1043.
11
4. Lu Y, T Ng, and Z Tao (2012). Outsourcing, Product Quality, and Contract Enforcement. Journal of Economics & Management Strategy 21: 130.
5. Ozanne A, T Hogan, and D Colman (2001). Moral Hazard, Risk Aversion and Compliance Monitoring in Agri-enviornmental Policy. European Review of Agricultural
Economics 28(3): 329-347.
6. Schmitz P (2010). Contractual Solutions to Hold-up Problems with Quality Uncertainty and Unobservable Investments. Journal of Mathematical Economics 46(5):
807-816.
7. Vetter H, K Karantininis (2002). Moral Hazard, Vertical Integration, and Public
Monitoring in Credence Goods. European Review of Agricultural Economics 29(2):
271-279.
12