Optimal Economic Governance with Incomplete Contracts and Search Frictions ∗

This article studies the interaction between incomplete contracts and a decentralized input market on the make-or-buy decision in a vertical industry relationship, considering both contractual and matching frictions. The downstream manufacturer trades off the cost of inefficient investments against the option value of continued search. It is costly to search because the production has inefficient input levels. It is beneficial to continue searching because the manufacturer can be matched with a better supplier. The model predicts that vertically integrated firms are more productive than non-integrated firms, and a sample of ex-ante identical manufacturers can choose different governance structures. Furthermore, the model predicts integration should be more prevalent in markets with larger matching frictions and with older manufacturers.