Consider an industry that produces a multicomponent product, assume that some of these components are specialized (industry specific), and assume further that among these are components for which the economies of scale m production are large in relation to the market. The market, then will support only a few efficient-sized producers for certain components.
A monopolistic excess of price-over-cost under market procurement is commonly anticipated in these circumstances – although, as discussed in Section 2 of Chapter 2, this need not obtain if there are large numbers of suppliers willing and able to bid at the initial contract award stage. Assume however that large-numbers bidding is not feasible. The postulated conditions then afford an apparent incentive for assemblers to integrate backward or suppliers to integrate forward. Two different cases can be lstmguished: bilateral monopoly (oligopoly) and competitive assembly with monopolistic supply. The former is considered here; the latter is treated in Section 1.3, above.
Bilateral monopoly requires that both price and quantity be negotiated Both parties stand to benefit, naturally, by operating on, rather than off, the contract curve-which here corresponds to the joint-profit maximizing quantity (Fellner, 1947). But this merely establishes the amount to be ex- changed. The terms at which this quantity will be traded still need to be determined. Any price consistent with non-negative profits to both parties is feasible. Bargaining can be expected to ensue. Haggling will presumably continue until the marginal private net benefits are perceived by one of the parties to be zero. Although this haggling is jointly (and socially) unproductive, it constitutes a source of private pecuniary gain. Nevertheless, being a joint profit drain, an incentive to avoid these costs, if somehow this could be arranged, is set up.
One possible adaptation is to internalize the transaction through vertical integration; but a once-for-all contract might also be negotiated. In a perfectly static environment (one that is free of disturbances of all kinds), these two alternatives may be regarded with indifference: the latter involves settlement on component supply price while a merger requires agreement on asset valuation. Bargaining skills will presumably be equally important in each instance (indeed, a component price can be interpreted in asset valuation terms). Thus, although vertical integration may occur under these conditions, there is nothing in the nature of the problem that requires such an outcome.
A similar argument in these circumstances also applies to adaptation against externalities: joint-profit considerations dictate that the affected parties reach an accommodation, but integration holds no advantage over once-for-all contracts in a perfectly static environment.
Transforming the relationship from one of bilateral monopoly to one of bilateral oligopoly broadens the range of bargaining alternatives, but the case for negotiating a merger agreement in relation to a once-for-all contract is not differentially affected on this account. The static characterization of the problem, apparently, will have to be relaxed if a different result is to be reached.
Consider, therefore, the contractual problem posed at the outset of the chapter: What organizational relations are to be expected if a set of tech- nologically separable work groups (each, say, organized as a simply hierar- chy) is engaged in recurring exchange of a small-numbers sort for which successive adaptations to uncertainty are required? Three types of organi- zational alternatives will be evaluated in the sections which follow: sales contracts, extensions on the model of simple hierarchy, and shifting to a multistage hierarchy in which the transactions in question are completed under an employment relationship.
Source: Williamson Oliver E. (1975), Markets and hierarchies: Analysis and antitrust implications, A Study in the Economics of Internal Organization, The Free Press.