Theory and empirical evidence both demonstrate that firms vertically integrate to bypass input market frictions, such as hold-up problems and market power. I propose a novel motivation for firms to vertically integrate: improving their bargaining position. Adding integrated capacity changes the firm’s threat point (outside option) to its integrated entity. The integrated firm can leverage this threat point change to improve its bargaining position vis-a-vis external firms. I define the threat point effect as the change in contracts caused by the change in threat point due to vertical integration. Then, I quantify it in the context of relational contracts between a large Indian garment manufacturer and its fabric suppliers, as firms bargain over surplus in relational contracts. This quantification speaks to central questions about the effects of and motivations for vertical integration, which influence competition policy. Additionally, the threat point effect shapes how buyers and suppliers share surplus in relational contracts, which is relevant to concerns about inequitable relational surplus sharing resulting in low prices for low-income country producers. First, I build a model of buyers and suppliers bargaining over relational contract surplus. It illustrates that different buyer and supplier types result in heterogeneous threat point effects. Then, structurally estimating the model results in threat point effects reducing relational contract prices up to 6.7% of pre-integration prices for small constrained firms that highly value profit smoothing from the relational contract. As policies often prioritize small firms, I analyze policies to reallocate surplus to them: i) increasing competition on the other side of the market and ii) creating the missing market, specifically insurance, that leads small firms to offer discounts in the relational contract. Only the latter shifts surplus to small firms.
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