Ensuring Corporate Social and Environmental Responsibility Through Vertical Integration and Horizontal Sourcing

Abstract

Firms have recently vertically integrated with suppliers to ensure corporate social and environmental responsibility (CSER) in sourcing. We investigate the conditions under which CSER concerns will drive vertical integration, and how actions of nongovernmental organizations (NGOs) impact CSER. This paper is inspired by Taylor Guitars’s acquisition of an ebony mill in Cameroon to ensure CSER. Whereas the majority of the responsible sourcing literature focuses on auditing as a mechanism for addressing CSER, we study vertical integration as an alternative. Our analysis confirms that CSER can be a potential driver of vertical integration aside from other well-known drivers. We analyze game-theoretical models where a firm can vertically integrate to potentially eliminate CSER risks. Two innovative features of our models are demand externalities (namely, a firm’s CSER violation can positively or negatively affect its competitor’s demand) and horizontal sourcing (namely, a vertically integrated firm can sell responsibly sourced supply to a competitor). We show that a firm’s CSER strategy depends on the risk of a CSER violation exposure, the level of demand externalities (positive or negative), and whether horizontal sourcing is feasible. We find that in industries where horizontal sourcing is unlikely, firms stay disintegrated under a low CSER violation exposure risk and vertically integrate under a moderate CSER violation exposure risk. Surprisingly, firms may stay disintegrated under a high CSER violation exposure risk combined with strongly negative demand externalities. In contrast, firms vertically integrate under moderate-to-high CSER violation exposure risk when horizontal sourcing is possible but may not share responsibly sourced supply through horizontal sourcing under strongly positive demand externalities. We show that firms should be conscious about demand externalities and the possibility of horizontal sourcing in the industry when considering vertical integration for CSER. We also provide guidance to NGOs interested in promoting CSER. When horizontal sourcing is unlikely, NGOs should specify both violating and nonviolating firms in their reports, but not over-scrutinize firms; whereas when horizontal sourcing is possible, NGOs should allocate more resources for scrutinizing firms’ CSER violations and create industry-wide violation reports, while avoiding naming of specific firms in their reports. This paper has been accepted for the Manufacturing & Service Operations Management Special Issue on Value Chain Innovations in Developing Economies.