Trade liberalization and domestic vertical integration: Evidence from China

Abstract In this study we examine the effects of trade liberalization on domestic backward vertical integration in which a domestic upstream firm (target) is acquired by a domestic downstream firm. We first build a relationship-specific investment model to guide and provide insights to our empirical work. Then we take China's accession to the WTO as a quasi-natural experiment for trade liberalization to test the theoretical predictions. Consistent with the model, we find that a decrease in tariffs on the target industry's outputs reduces vertical integrations, but a decrease in tariffs on the target industry's inputs increases vertical integrations. The findings are robust to various specifications of the empirical model and measurements of the variables. We further show that underinvestment problem is an important mechanism to understanding the effects of tariff reductions on firms' organizational choices.