Fiat without Authority under Vertical Integration

Abstract

This paper develops a relational contracting model to show how fiat - a principal's ability to dictate her agent's performance - emerges in equilibrium under vertical integration, even when integration does not allocate distinctive formal authority to the principal. In a vertical structure, an efficient relational contract requires the downstream manager to take actions that maximize agrregate profits, in exchange for future rents. If the manager of a vertically integrated unit reneges, she benefits from greater free time, but does not appropriate the associated increase in unit profits. Therefore, when the actions that maximize aggregate profits and the individual unit's profits differ substantially - that is, when interest conflicts and spillovers between units are large - the manager's promise to perform will be more credible under vertical integration than under separation.