In this paper, we propose and provide evidence that the existence of prior social connections between managers or board members of supplier (upstream) and customer (downstream) firms can encourage relation-specific investment and foster innovation by the upstream firms. We show that innovative activities by suppliers increase with the existence and strength of their social connections with customers. To establish causality, we exploit connection breaches due to manager/director retirements or deaths in the (much larger) customer firms and find that innovative activities drop for those suppliers connected to these customer members. Our work sheds light on how social connections can shape the boundary of the firm by mitigating contractual incompleteness and transactions costs, thereby allowing the upstream firms to remain as standalone entities instead of being vertically integrated with the downstream firms.
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