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Ownership, Incentives, and the Hold-Up Problem

Vertical integration is often proposed as a way to resolve hold-up problems, ignoring the empirical fact that division managers tend to maximize divisional (not firmwide) profit when investing. This paper develops a model with asymmetric information at the bargaining stage and investment returns taking the form of cash and "empire benefits". Owners of a vertically integrated firm then will provide division managers with low-powered incentives so as to induce them to bargain "more cooperatively", resulting in higher investments and overall profit as compared with non-integration. Thus, vertical integration mitigates hold-up problems even without profit sharing.