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  • The editor in charge of this paper was Fabrizio Zilibotti.

  • Acknowledgments: Warwick University and CEPR. I am especially indebted to Tim Besley and Maitreesh Ghatak for their support, Abhijit Banerjee for encouraging me at the beginning of this project, the Editor, Fabrizio Zilibotti, and three anonymous referees for their comments. I also thank Oriana Bandiera, Marianne Bertrand, Robin Burgess, Dave Donaldson, Mikhail Drugov, Aytek Erdil, Leonardo Felli, Sharun Mukand, Steve Pisckhe, Xavier Ragot, Imran Rasul, Philipp Schmidt-Dengler, John Sutton, Eric Verooghen, Fabian Waldinger, Chris Woodruff, participants at NEUDC 2005, ESSFM 2006 and CEPR/EUDN conferences, and seminars at Berkeley, Bocconi, Essex, HEC Paris, IFS, IIES, LSE, Maryland, Munich, Oxford, PennState, PSE-Jourdan, and UvA for useful comments. Macchiavello is a member of the CEPR. All errors are mine.



Existing evidence is mostly inconclusive on the relevance of financial development as a determinant of vertical integration. This paper presents evidence that, once industry heterogeneity in firm size distribution is taken into account, financial development is an important determinant of cross-country differences in vertical integration. Financial development fosters entry of firms and increases competition in the industry. This reduces vertical integration of larger firms, but also leads smaller, non-integrated, firms to exit the industry. As a result, higher financial development reduces vertical integration in industries where a high share of output is produced by small firms. The positive effect of financial development on entry also reduces vertical integration by fostering the development of input markets.