The Limits of Firms: Integration of an Owner-Managed Supply Stage

The obvious answer to the puzzle of why firms do not comprehensively integrate is that selective intervention is not feasible. But why should that be? If the reasons were obvious, the puzzle of what is responsible for limitations on firm size would not persist.

I attempt here to identify some of the main reasons why selective intervention breaks down. So as to facilitate the argument, assume that an owner- managed supplier is acquired by the buyer.4 Assume that this ownership change is accomplished as follows:

  1. A price at which the assets are transferred is agreed to
  2. The formula for determining the price at which product is to be transferred from the supply division to the buying division is stipulated.
  3. So as to encourage cost economizing, the high-powered incentives that characterize markets are carried over into the firm. Accordingly, the supply division is advised that it will appropriate its net revenues— which are defined as gross revenues less the sum of operating costs, user charges (for asset maintenance and depreciation), and other relevant expenses (e.g. for R & D).
  4. Selective intervention will obtain. Accordingly, the supply division is advised to conduct business as usual with the following exception: The supplier will accede to decisions by the buyer to adapt to new circumstances, thereby to realize collective gains, without resistance.5 Failure to accede is cause for and gives rise to termination.

Unified ownership of the assets of the two stages thus (1) preserves high- powered incentives (rule 3), (2) provides for selective intervention (rule 4), and (3) precludes costly haggling (rule 4). The last two features permit adaptive sequential decision-making economies to be realized by merging what had previously been nonintegrated stages of

Implicit in the argument is the assumption that the two stages are operating in a bilateral exchange relation with each other by reason of investments in transaction-specific assets. Such specificity can take at least four forms: site specificity, physical asset specificity, human asset specificity, and dedicated assets. It will be convenient here to consider only physical asset specificity.

Indeed, given rule 4 above, human asset specificityls effectively ruled out. As developed more fully in Chapter 10, it is in the mutual interests of firm and worker to, safeguard the employment relation against abrupt termination (by either party) wherever labor develops firm specific skills and knowledge during the course of its employment. Accordingly, the rule do this/do that or terminate is maladapted to the needs of the parties where firm-specific human assets are considerable.54 The argument here therefore assumes that the bilateral exchange relation is due entirely to a condition of physical asset specificity. Rule 4 thus applies, whereunder failure to accede to any order to adapt will be cause for termination. Upon realization that successor managements can always be brought in to implement change orders as requested, the incumbent management always acquiesces.

Were this the end of the story, selective intervention with net gains would presumably obtain. In fact, however, numerous measurement difficulties stand in the way of implementing a merger agreement that is attended by high powered incentives. Some of them operate to the disadvantage of the buyer, some work to the disadvantage of the supplier, and others impose losses on both.

1. Asset Utilization Losses

The former owner-manager of the supply stage becomes the manager of the supply division upon sale of the supply stage assets to the buyer. The change of status has immediate and serious incentive effects if the high-powered incentive rules described above are employed. For one thing, the manager who appropriates the net receipts associated with the supply division no longer has the same incentives to utilize equipment with equivalent care and to incur identical preventive maintenance. Since, by assumption, the manager has no firm- specific human assets at stake, the manager behaves myopically with respect to the enterprise. The object being to maximize immediate net receipts, labor costs will be saved by utilizing equipment intensively, and maintenance expense will be deferred to a successor management. Having been paid for his assets upon giving up ownership status, the manager of the supply division proceeds to run them into the ground and leaves the firm to invest his augmented net receipts elsewhere.

To be sure, there are checks against asset abuses of both kinds. The new asset owner may insist that certain utilization and maintenance procedures be observed and furthermore monitor the supply division for compliance. Note, however, that added monitoring costs—unneeded in the nonintegrated state—have now been introduced. Additionally, reputation effects can deter managers from behaving irresponsibly. These, however, are imperfect. Some managers may shrug them off if the immediate gains are large enough and if they cannot be required to disgorge their ill-gotten gains. (Swiss bank accounts have attractive features in that respect.)

The upshot is that efficient asset utilization and the use of high-powered incentives experience tensions in an integrated firm—tensions that do not arise when the two production stages are independent. Contrary to the type of selective intervention that 1 postulated in section 1, the integrated firm cannot wholly replicate outside procurement in “business as usual” respects. Instead, there are unavaoidable side effects.

 2. Accounting Contrivances

The price at which a supplier agrees to sell his assets to the buyer will vary with the stream of net receipts that he projects in the post merger period. ‘ Given the high-powered incentives described above, that stream will vary with (1) revenues, (2) costs, and (3) continued employment.

One hazard is that the supplier will be “promised” a favorable net receipt stream, hence accept a low price for transferring asset ownership, only to learn to his dismay that his employment has been terminated. Suppose, out of awareness of such a hazard, the supplier demands and receives a guarantee of continued employment. Such guarantees accomplish little, however, if the net receipts of the supply division can be altered substantially through the exercise of accounting discretion. Expropriation can then be accomplished by indirection. Net receipts can be squeezed in either or both of two ways. For one, revenues can be reduced by cutting transfer prices. For another, cost imputations can be raised. The supply division is vulnerable in both respects.

Given the impossibility of comprehensive contracting, the transfer pricing rule that is stipulated at the outset will necessarily be incomplete. So as to correct against misalignments, prices will need to be reset periodically to reflect changing circumstances. This can be done by consulting the market if asset specificity is zero. Complications intrude, however, when even a slight degree of asset specificity appears. Thus although the terms under which product is traded between autonomous parties are disciplined by the credible threat that the supplier will retire his specialized assets, rather than use them to support the supplier’s specialized procurement needs, if mutually acceptable terms are not reached, the manager of the supply division in the integrated firm does not have the same option.)lf push comes to shove, the physical assets are no longer his to retire (or, more generally, redeploy). Employment guarantees notwithstanding, the manager of the supply division can, if he refuses to accept the proposed terms, be brushed aside. (He is simply “reassigned.”) Upon merger, therefore, the determination of transfer prices has, in effect, become a decision for the purchasing division (which now owns the assets of both parts) to reach unilaterally. The hazard is obvious: Despite assurances to the contrary, prices will be set so as to squeeze the net receipts of the supply stage.

Cost determination is problematic, moreover, whatever the degree of asset specificity. Whereas each stage determines its own accounting practices in the pre-merger regime, that is no longer permitted—indeed, is wholly implausible— upon merger. Instead, responsibility for the accounting rules will be concentrated on the asset owner.56 Explicit agreements that limit accounting discretion notwithstanding, the supply stage runs the risk that costs will be reset to its disadvantage.

The upshot is that the supply stage is better advised to discount very heavily any promise that favorable net receipt streams are in prospect and to realize its full bargaining advantage by extracting maximum asset valuation terms at the outset—because a squeeze is in prospect thereafter. But there is more to it. If the use of high-powered incentives in firms is inherently subject to corruption, then the notion that the integrated firm can do everything that the nonintegrated parts could accomplish is a fiction. Instead, the integrated firm does better in some respects and worse in others.

3. Incentive Ramifications and βo

High-powered incentives in firms give rise to difficulties of two kinds: The assets of the supply stage are not utilized with due care, and the net revenue stream of the supply stage is subject to manipulation. Upon realization that high-powered incentives in firms experience such disabilities, lower-powered incentives are apt to be introduced instead. Were the supply stage management to be compensated mainly by salary and become subject to periodic monitoring (decision review, auditing, and the like), the supply stage would have less need to be concerned with accounting chicanery, and the asset owner’s concern with asset dissipation would be lessened.

Low-powered incentives have well-known adaptability advantages. That, after all, is what commends cost plus contracting. But such advantages are not had without cost—which explains why cost plus contracting is embraced reluctantly (Williamson, 1967a). Our first explanation for why firms do not everywhere supplant markets thus is that (1) firms cannot mimic the high- powered incentives of markets without experiencing added costs; (2) although recourse by firms to lower-powered incentives is thereby indicated, that too comes at a cost; and (3) those added costs of internal organization are not offset by comparative adaptability gains under circumstances where k = 0, since those are precisely the conditions under which the identity of the patties does not matter, whence classical market contracting works well. The net governance costs of acquiring an owner-operated supply stage are thus positive where asset specificity is slight. A β0 > 0 condition thereby obtains.

More generally, the argument is this: Incentives and controls are adapted to the attributes of each organizational alternative. To attempt to “hold the rules as nearly constant as possible,” on the theory that what works well in one regime ought to apply equally to another, is thus mistaken. The powers and limits of each form of organization must be discovered and respected.

4. Innovation

The foregoing makes no reference to innovation. Implicitly, product and process innovations are unimportant. Transactions are moved from markets to hierarchies as asset specificity builds up because the high-powered incentives in firms operate as a disability when adaptations to stochastic or other disturbances are attempted in a tightly bilateral trading context.

How, if at all, is the assignment of transactions to markets and hierarchies altered by the introduction of process or product innovations? Unfortunately, the study of innovation is enormously complex (Phillips, 1970; Nelson, 1984). Some large corporations maintain that innovation can be and has been successfully bureaucratized: “We employ many people who, if left to their own devices, might not be research-minded. In other words, we hire people to be curious as a group. We are undertaking to create,research capability by the sheer pressure of money.” As discussed in subsection 6.4 below, however, there appear to be some projects for which the use of high- powered incentives elicits superior research results. How do nonintegrated and integrated supply stages compare in supplying incentives for innovation?

The issues are many-sided. An obvious advantage of integration is that research and development cooperation between stages may be easier to elicit. But there are at least two incentive-impairing effects.


As discussed in subsection 4.2, below, reasoning systems are expected to behave in reasoning ways. Administrative boundaries are much easier to breach than are market boundaries when demands for reason are expressed.

Thus if a .supply division in an integrated firm is largely but not wholly responsible for the success (failure) of an innovative effort, it may be difficult to concentrate the benefits (costs) in such a way as to reflect that condition. To illustrate, suppose that the purchasing stage proposes that the supply stage consider a process or product innovation. Contrast the results if the supply stage is integrated or independent and if the proposal is successful or not. Assume in any event that the supply stage incurs nontrivial costs in conducting ihe necessary research and development.

Ownership autonomy in the nonintegrated regime will serve to concentrate the net benefits of both failures and successes on the independent supply stage. The uncorrupted use of high-powered incentives in firms would do the same. But whereas the requests of an independent purchaser are apt to be dismissed should it ask for its “fair share” of the gains, an integrated purchasing stage is much more likely to prevail in asking that its significant contribution to the project be acknowledged. Not only does fairness dictate that the rewards be shared, but to do otherwise would result in large compensation disparities between the two stages. Those in turn would thereafter give rise to invidious comparisons. Since the firm has the discretion to remedy the disparities by administrative decision, and since to do otherwise poses severe strains, the high- powered incentives of markets are apt to be compromised.

The ex post weakening of incentives for innovation does not, however, come without cost. The management of the supply division will anticipate that similar pressures will arise in the future—which is to say that, the rules notwithstanding, high-powered incentives in firms are subject to degradation.11


Even if the division of benefits between supply and purchasing stages could be decided objectively, there is serious doubt that an ex ante agreement to distribute a pro rata share of the rewards will be respected. Instead, a redistribution away from the operating parts in favor of the ownership is apt to be effected by manipulation of the transfer pricing and cost accounting rules.

To be sure, the management of an independent supply stage also runs the risk that the ownership will keep two sets of books. True performance results could thus be disguised. The relevant question, however, is one of degree. If integration ordinarily permits greater accounting discretion, which it arguably does (see subsection 2.2 above), then the results of innovation are more easily obfuscated in the integrated state.

Moreover, even if the ownership of an integrated firm were to resist manipulation of that kind, high-powered incentives to innovate need not obtain. The problem is one of information asymmetry/impactedness. If it is very costly to prove that manipulation has not occurred, then, ownership promises of good behavior notwithstanding, managers will be continuously suspect that it will occur—in which case their incentives are unavoidably impaired.


The introduction of innovation plainly complicates the earlier-described assignment of transactions to markets or hierarchies based entirely on an examination of their asset specificity qualities. Indeed, the study of economic organization in a regime of rapid innovation poses much more difficult issues than those addressed here. Nevertheless, it may be instructive to examine a narrow construction of the problem.

Thus consider a firm that has the need for the continuing supply of goods and services that differ not merely in asset specificity respects but also in terms of their innovative potential, where the latter has reference to the degree to which a good or service is susceptible to cost-saving improvements. The earlier argument—that goods and services that are supported by nonspecific assets will be procured in the market and that the balance shifts in favor of vertical integration as asset specificity deepens—remains intact in circumstances where the innovative potential is slight. Differences, therefore, if there are any, are concentrated in the regime where innovative potential is great.

It is useful in this connection to distinguish between cost savings that arc generic and thosç that are proprietary. Generic cost savings are ones that are quickly recognized and easily imitated by rival suppliers. Patents, copyrights, trade secrets, and the like afford little protection for these. Those that are proprietary, by contrast, are ones for which the benefits of innovation can be appropriated.

In principle, both generic and proprietary cost savings can be supported by assets of either nonspecific or specific kinds. Easy imitation, however, is ordinarily associated with nonspecific investments. Accordingly, market pro- curement of goods or services of the generic cost-saving kind will usually pose little bilateral dependency or profit strain, whence market procurement is normally indicated. The procurement of items for which cost savings are proprietary, especially those that are supported by transaction specific assets, is another matter.

The tension here is that while the buyer will want both to participate in the benefits of innovation and to encourage supply stage investments of an efficient (transaction specific) kind, the supplier’s incentives to innovate (which entails the realization of cost savings of a subtle, nonobvious, and often noncomparable kind) will be diminished if the supply stage is integrated.58 A complex tradeoff situation is thus posed when the potential incen-tive benefits are great and the transaction is characterized by substantial asset specificity. New hybrid forms of organization may appear in response to such a condition. (Innovative organizational forms in the semiconductor industry are illustrative [Levin, 1982]. Although the discussion of hybrid forms in Chapters 7 and 8 is apposite, the examples in subsection 6.4 below are closer to the point. Much more study of the relations between organization and innovation is needed.)

Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.

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