Do firm boundaries matter?

de Sendhil Mullainathan

In his famous article, "The Nature of the Firm," Ronald Coase (1937) raised two fundamental questions that have spawned a large body of research: Do firm boundaries affect the allocation of resources? And, what determines where firm boundaries are drawn? While the first of these questions has received some theoretical attention - notably Oliver Williamson (1975, 1985), Benjamin Klein, Robert Crawford, and Armen Alchian (1978) and Sanford Grossman and Oliver Hart, (1986) - it has largely been ignored empirically. Instead, the empirical work in this area, discussed in the other articles in this session, has addressed the second question by analyzing the determinants of vertical integration. Thus, while we know something about the forces that determine firm boundaries, we know relatively little about how these boundaries affect actual firm behavior. This is a major limitation in our understanding of the nature of the firm. To begin to assess how firm boundaries affect behavior, we analyze whether there are differences between integrated and non-integrated chemical manufacturers in their investments in production capacity. We focus on producers of vinyl chloride monomer (VCM), the sole use of which is in the production of the widely used waterproof plastic, polyvinyl chloride (PVC). VCM is a homogenous commodity and is traded in relatively liquid markets. Moreover, there is no obvious production link between VCM and PVC other than that one is an input into the other. For example, PVC is not a by-product of VCM production. Nevertheless, two thirds of VCM producers in our sample are integrated downstream into PVC. The existing literature would ask why we observe this degree of integration. We ask instead whether integrated and non-integrated VCM producers invest differently in production capacity.