Intermediate product markets and vertical integration: Concluding Remarks

Vertical integration is favored in circumstances where small-numbers bargaining would otherwise obtain — whether this prevails from the very outset or because, once the initial contract is let, the parties to the transaction are effectively “locked in” at the recontracting interval — and where, in the face of uncertainty and on account of bounded rationality, an adaptive, sequential decision-process has optimal properties. Vertical integration economizes on transactions by harmonizing interests and permitting a wider variety of sensitive incentive and control processes to be activated. Thus, the hazards [see Fellner (1949, Chaps. 5-7) ] of defection and cheating that are posed when a qualified joint profit maximization agreement is reached between (what continue to be) autonomous or semi-autonomous units are greatly reduced if a comprehensive pooling (that is, merger) agreement is reached instead. For one thing, claims over individual profit streams in the latter case are relinquished — not merely when it suits the purposes of the parties, but on an assuredly continuing basis. Also, as noted in the discussion of group disciplinary effects, the members of a firm generally have stronger infrastructure preserving interests than do the members of more loosely knit associations.

Significant constitutional differences also obtain. Thus, the authorized powers to perform an audit are extended and the degree of cooperation that can be secured from those who are subject to the audit is enhanced if the parties are associated through a merger rather than under a qualified joint- profit maximization agreement. Moreover, the compliance instruments that the firm can bring to bear on its employees to promote favored and discourage disfavored outcomes are more refined and selective than would be admissible under (or for that matter consistent with) a joint-profit maximization agreement in which the parties maintain genuine autonomy.

As a result, instrumental conflicts can be resolved more efficiently; cooperative adjustments to changing market circumstances are promoted. Moral hazards are attenuated, externalities are internalized (which economizes on imputation expenses and overcomes defective property rights assignments), and efficient factor proportions are restored where distortions due to monopolized inputs would otherwise exist. Efficient information exchange, including observational economies, is facilitated, in both accuracy and veracity senses, as well as the convergence of what otherwise would be disparate expectations. Supply reliability that might otherwise be impaired by antagonistic interests, including even malevolence, is better assured.

The discussion of internal organization in this and in previous chapters deals with only elementary forms of hierarchy and relatively simple types of adaptive behavior. The management of a complex firm, however must deal with such issues as (1) the redeployment of internal resources in response to environmental disturbances in kind, (2) strategic planning, including innovation, and (3) preserving (or not degrading) intrafirm atmosphere as firm size is scaled up. In addition, the eventual limits to internal organization need to be assessed. Aspects of these issues are addressed in the chapters which follow.

Source: Williamson Oliver E. (1975), Markets and hierarchies: Analysis and antitrust implications, A Study in the Economics of Internal Organization, The Free Press.

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