Vertical Integration: A Heuristic Model

As discussed in earlier chapters and sketched in section 1 above, the principal factor to which transaction cost economics appeals to explain vertical integration is asset specificity. Without it, market contracting between successive production stages ordinarily has good economizing properties. Not only can production economies be realized by an outside supplier who aggregates orders, but the governance costs of market procurement are negligible—since neither party has a transaction-specific interest in the continuity of the trade. As asset specificity increases, however, the balance shifts in favor of internal organization.

The argument is developed in two parts. First, output is held constant and economies of scale and scope are assumed to be negligible (or the firm in question is of sufficient size to exhaust them). Choice between firm and market thus turns entirely on governance cost differences. Second, economies of scale and scope are admitted, but output is constrained to be the same.

1. Governance Costs and Economic Organization 

The main differences between market and internal organization are these: (1) Markets promote high-powered incentives and restrain bureaucratic distortions more effectively than internal organization; (2) markets can sometimes aggregate demands to advantage, thereby to realize economies of scale and scope; and (3) internal organization has access to distinctive governance instruments: The differences between market and internal organization in incentive and control respects are developed in Chapter 6. For my purpose here, I take these as given.

Consider, therefore, the decision of a firm to make or buy a particular good or service. Suppose that it is a component that is to be joined to the mainframe and that the quantity to be supplied is fixed.7 Economies of scale and scope are assumed to be negligible, so the critical factors that are deter-minative in the decision to make or buy are production cost control and the ease of effecting intertemporal adaptation.

FIGURE 4-1. Comparative Governance Cost

The high-powered incentives of markets manifest themselves in both respects: They favor tighter production cost control but, as the bilateral depen- dency of the relation between the parties builds up, they impede the ease of adaptation. The latter effect is a consequence of the fundamental transformation that occurs as a condition of asset specificity deepens. Let β(k) be the bureaucratic costs of internal governance and M(k) the corresponding gover- nance costs of markets, where k is an index of asset specificity. Assume that β(0)> M(0), by reason of the above described cost control effects. Assume further, however, that M’ > β’ evaluated at every k. This second is a consequence of the comparative disability of markets in adaptability respects. Letting ΔG = β(k) ~ M(k), the relation shown in Figure 4-1 obtains.

Thus market procurement is the preferred supply mode where asset spec- ificity is slight—because of the incentive and bureaucratic disabilities of internal organization in production cost control respects. But internal organization is favored where asset specificity is great, because a high -degree of bilateral dependency exists in those circumstances and high-powered incentives impair the ease with which adaptive, sequential adjustments to disturbances are accomplished. As shown, the switchover value, where the choice between firm and market is one of indifference, occurs at k.

2. Economies of Scale and Scope 

The foregoing assumes that economies of scale and scope are negligible, so that the choice between firm and market rests entirely on the governance cost differences. Plainly that oversimplifies. Markets are often able to aggregate diverse demands, thereby to realize economies of scale and scope. Accordingly, production cost differences also need to be taken into account.

Again it will be convenient to hold output unchanged. Let AC be the steady state production cost difference between producing to one’s own re- quirements and the steady state cost of procuring the same item in the market. (The steady state device avoids the need for adaptation.) Expressing AC as a function of asset specificity, it is plausible to assume that AC will be positive throughout but will be a decreasing function of k.

The production cost penalty of using internal organization is large for standardized transactions for which market aggregation economies are great whence AC is large where k is low. The cost disadvantage decreases but remains positive for intermediate degrees of asset specificity. Thus although dissimilarities among orders begin to appear, outside suppliers are nevertheless able to aggregate the diverse demands of many buyers and produce at lower costs than can a firm that produces to its own needs. As goods and services become very close to unique (k is high), however, aggregation economies of outside supply can no longer be realized, whence AC asymptotically approaches zero. Contracting out affords neither scale nor scope economies in those circumstances. The firm can produce without penalty to its own needs.

FIGURE 4-2. Comparative Production and Governance Costs

This ΔC relation is shown in Figure 4-2. The object, of course, is not to minimize ΔC or ΔG taken separately but, given the optimal or specified level of asset specificity, to minimize the sum of production and governance cost differences. .The vertical sum ΔG + ΔC is also displayed. The crossover value of k for which the sum (ΔG + ΔC) becomes negative is shown by k, which value exceeds k. Economies of scale and scope thus favor market organization over a wider range of asset specificity values than would be observed if steady state production cost economies were absent.

More generally, if k* is the optimal degree of asset specificity, Figure 4-2 discloses:

  1. Market procurement has advantages in both scale economy and gov- ernance respects where optimal asset specificity is slight (k* « kˆ). 
  1. Internal organization enjoys the advantage where optimal asset speci- ficity is substantial (k* » k). Not only does the market realize little aggregate economy benefits, but market governance, because of the “lock-in” problems that arise when assets are highly specific, is hazardous.
  1. Only small cost differences appear for intermediate degrees of optimal asset Mixed governance, in which some firms will be observed to buy, others to make, and all express “dissatisfaction” with their current procurement solution, are apt to arise for these. Accidents of history may be determinative. Or nonstandard contracts of the types discussed briefly in Chapter 3 and examined more fully in Chapters 7 and 8 may arise to serve these.
  2. More generally, it is noteworthy that, inasmuch as the firm is every-where at a disadvantage to the market in production cost respects (ΔC > 0 everywhere), the firm will never integrate for production cost reasons Only when contracting difficulties intrude does the firm and market comparison support vertical integration—and then only for values of k* that exceed kˆ.

Additional implications may be gleaned by introducing quantity (or firm size) and organization form effects. Thus consider firm size (output). The basic proposition here is that diseconomies associated with own-production will be everywhere reduced as the quantity of the component to be supplied increases. The firm is simply better able to realize economies of scale as its own requirements become larger in relation to the size of the market. The curve AC thus everywhere falls as quantity increases. The question then is what happens to the curve AC. If this twists about ic, which is a plausible construction, then the vertical sum ΔG + ΔC will intersect the axis at a value of k that progressively moves to the left as the quantity to be supplied increases. Accordingly:

  1. Larger firms will be more integrated into components than will smaller, ceteris paribus.

Finally, although this anticipates arguments developed more fully in Chapter 11, the bureaucratic disabilities to which internal organization is subject vary with the internal structure of the firm. Multidivisionalization, assuming that the M-form is feasible, serves as a check against the bureaucratic distortions that appear in the unitary form (U-form) of enterprise. Expressed in terms of Figure 4-2, the curve ΔG falls under multidivisionalization as compared with the unitary form organization. Thus, assuming AC is unchanged:

  1. An M-form firm will be more integrated than its U-form counterpart, ceteris paribus.

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

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