In-House and Arm's Length: Productivity Heterogeneity and Variation in Organizational Form

This paper investigates why a firm vertically integrates with some suppliers and outsources production to others. In a simple model of organizational form choice with firm-supplier productivity heterogeneity, we illustrate how explicit performance incentives that reduce contractual incompleteness interact with incentives related to ownership in determining firm boundaries. Evidence from the U.S. hotel industry suggests that both types of incentives help explain observed variation in organizational form. For most hotel brands, the least- and most- productive properties are managed at arm's length by franchisees and intermediate-productivity hotels are vertically integrated. This sorting pattern is not observed for the highest-tier brands.