Making sense of inefficient intrafirm transactions: A signalling approach

We provide a signalling model of inefficient intrafirm transactions. If an integrated firm retains the option of buying intermediate goods in the open market, the decision to make or buy can be a signal about its cost of producing the intermediate good. In particular, the decision to supply internally can be a signal that its internal production cost is favorable compared with the market price. Consequently, a firm with a higher cost than the market price might have an incentive to mimic the firms with a lower cost; it forgoes the chance to buy from the market at a lower acquisition cost in order to induce output contraction by the rival firm in the final product market. This incentive for signalling will lead a firm which would otherwise buy from the market to supply internally, because of the strategic consequences in the downstream market.