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We explore patterns of vertical integration in the US airline industry. Major air lines subcontract portions of their network to regional partners, which may or may not be owned. We investigate if ownership economizes on ex post renego tiation costs. We estimate whether airlines are more likely to use owned region als on city pairs with adverse weather {which makes adaptation decisions more frequent) and on city pairs that are more integrated into the major's network (which raises the costs of having adaptation decisions resolved suboptimally). Our results suggest a robust empirical relationship between adaptation and vertical integration in this setting. (JEL L14, L22, L24, L93) How do firms decide which transactions to carry out in-house and which to procure through the market? In response to this question, a large theoretical literature has developed. One branch of this literature-transaction cost economics-argues that integration may be a more efficient way to organize when contracts are incomplete and parties cannot easily switch trading partners (Oliver Williamson 1975, 1985).J Under these conditions, ex post renegotiation will be both nec essary and costly and, as a result, the transaction costs of market exchange may be substantial. Empirical studies testing this hypothesis have focused primarily on the effect of asset specific ity on vertical integration and have generally found a positive relationship.2 However, as Steven Tadelis (2002) emphasizes, holding asset specificity constant, variation in transaction costs will also result from differences in transaction complexity. Complex transactions are associated with greater contractual incompleteness, and in turn more costly haggling over ex post adaptation decisions. Yet, relative to asset specificity, the frequency of adaptation decisions as a determinant of vertical integration has received considerably less attention in the empirical literature.3 |
