The preceding discussion has been concerned mainly with the vertical integration of successive production stages. But the institutional failures framework applies more generally. Franchising, for example, can usefully be studied in these terms. Forward integration into wholesaling is another illustration. Consider Holton’s discussion of the wholesaling issue.
Holton (1968, pp. 151-153) contends that the incentives to integrate manufacturing and wholesaling stages increase as:
- The sale of the manufacturer’s product becomes more geographically dense.
- The greater the average order size placed by retailers.
- The greater the proportion of a retail firm’s sales accounted for by the product of the manufacturer.
- The more important the services of the wholesaler are to effective distribution and the promotion of sales.
- The greater the physical perishability or style obsolescence of the product.
- The greater the number of efficient-sized wholesaling outlets needed to service the requirements of the manufacturer.
- The greater the possibility of reducing decision-making to a routine.
Incentives numbered 1, 2, and 3 favor the creation of specialized whole- saling outlets in order to more fully realize economies of distribution — especially if the wholesaling function is important and calls for the training of specialized sales and service personnel. The shift from general to specialized wholesaling reduces the number of wholesale outlets and may result in a small-numbers relation between manufacturer and wholesaler. The small-numbers bargaining indeterminacies, which predictably develop, can be avoided by integrating forward into wholesaling.
Incentive number 4 involves matters of inventory investment, product complexity, and service reliability. If large inventories are required to handle demand uncertainties, a problem of who is to bear the risk in what way is posed. Selling on consignment shifts the risk to the producer but may induce the distributor to carry an excessive inventory. Product complexity and service reliability are apt to favor specialized training. Such product-specific investments easily give rise to small-numbers bargaining problems if the parties are associated in a sales rather than an employment relationship.
Incentive number 5 poses the uncertainty issue in even more explicit terms. The desirability of coordinating decision-making through internal, adaptive, sequential processes rather than by contract is enhanced as physical perishability or style obsolescence increase.
Incentive number 6 is somewhat puzzling. There is no clear transactional advantage that I can discern for this condition — unless, perhaps, there are economies of finance to be realized. Reducing decision-making to a routine (incentive number 7) presumably implies economies of writing performance programs (see Section 4.1, above).
Forward integration into wholesaling would thus appear to be explained largely by the same types of transactional considerations that apply to the vertical integration of successive production stages. This is encouraging in that, to the extent that we have been successful in getting to core issues, one would hope that the approach would have general application.
Source: Williamson Oliver E. (1975), Markets and hierarchies: Analysis and antitrust implications, A Study in the Economics of Internal Organization, The Free Press.