Divided we Stand, United we Fall: Asset Specificity and Vertical Integration Reconsidered

Recent surveys and casual observation suggest that higher levels of asset specificity need not always lead to vertical integration, as traditionally stressed by transaction-cost economics. This paper uncovers some of the factors driving firms to (sometimes) choose to remain separated in the presence of high specificity. It shows that in a world where outside options matter and investments are multidimensional, high asset specificity can foster nonintegration: a low level of specificity provides the most misdirected incentives when transacting in a market (because the outside option of external trade becomes so tempting), thus making a stronger case for nonintegration.