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Digitized by the Internet Archive in 2011 with funding from Boston Library Consortium Member Libraries http://www.archive.org/details/dofirmboundariesOOmull DEWEY i~ Massachusetts Institute of Technology Department of Economics Working Paper Series DO FIRM BOUNDARIES MATTER? Sendhil Mullainathan David Scharfstein Working Paper 01 -05 January 2001 Room E52-251 50 Memorial Drive MA Cambridge, 02142 This paper can be downloaded withoutchargefrom the Social Science Research Network Paper Collection at http://papers.ssrn.com/paper.taf7abstract id=259926 Massachusetts Institute of Technology Department of Economics Working Paper Series DO FIRM BOUNDARIES MATTER? Sendhil Mullainathan David Scharfstein Working Paper 01 -05 January 2001 Room E52-251 50 Memorial Drive MA Cambridge, 021 42 This paper can be downloaded without charge from the Social Science Research Network Paper Collection at http://papers.ssrn.com/paper.taf7abstract _id=259926 MASSACHUSfcl IS INSTITUTE J OFTECHNOLOGY AUG 2 2 2001 LIBRARIES Do Firm Boundaries Matter? Sendhil Mullainathan and David Scharfstein* In his famous article, "The Nature ofthe Firm," Ronald Coase (1937) raised two fundamental questions that have spawned a large body ofresearch: Do firm boundaries affect the allocation ofresources? And, what determines where firm boundaries are — drawn? While the first ofthese 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 ofvertical 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 ourunderstanding ofthe nature ofthe 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 ofvinyl chloride monomer (VCM), the sole use ofwhich is in the production ofthe widely used waterproofplastic, VCM polyvinyl chloride (PVC). 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 VCM production. Nevertheless, two thirds of producers in our sample are integrated downstream into PVC. The existing literature would ask why we observe this degree ofintegration. We ask instead whether integrated and non-integrated VCM producers invest differently in production capacity. Data I. Our analysis is based on a global dataset ofVCM and PVC manufacturers provided to us by SRI Consulting, Inc., a firm based in Menlo Park, CA. The dataset contains detailed plant-level information on VCM and PVC production capacities from 1974 to 1998 in 61 countries. It also includes country-level information on production VCM and consumption of and PVC, but no information on prices and plant-level production. We construct firm-level production capacities ofVCM and PVC by We aggregating this data across plant-level observations. restrict our analysis to firms operating in consistently market-based economies with a minimum level ofGDP. This leaves us with 1257 observations in 17 countries. Table 1 provides summary information on the firms in our sample. The average VCM firm accounts for 13.2% ofcountry capacity (280.15/21 15.72). Integrated firms account for two thirds ofthe observations.1 These firms differ themselves in the nature of VCM their integration. The firms that have more production capacity than they can consume internally, we label as merchant firms because they likely sell part oftheir VCM output to the outside market. Other firms have less capacity than they need for downstream PVC production. Because these firms likely only supply to downstream PVC plants that they own, we label them captiveproducers. VCM To measure whether producers are merchant or captive, we calculate the — internal demand ratio the ratio ofa firm's demand for VCM from its own PVC plants VCM to the upstream supply of (assuming both types ofplants operate at full capacity). VCM This calculation uses information on the units of required to produce one unit of PVC.2 The internal demand ratio is zero for non-integrated VCM producers; positive but