Vertical Integration: Further Implications

1. Asset Specificity Distinctions 

Additional implications of a transaction cost economizing kind can be derived by recognizing that asset specificity takes a variety of forms and that the organizational ramifications vary among these. Four types of asset specificity are usefully distinguished: site specificity—e.g. successive stations that are located in a cheek-by- jowl relation to each other so as to economize on inventory and transportation expenses; physical asset specificity e.g. specialized dies that are required to produce a component; human asset specificity that arises in a leaming-by-doing fashion; and dedicated assets, which represent a discrete investment in generalized (as contrasted with special purpose) production capacity that would not be made but for the prospect of selling a significant amount of product to a specific customer. The organizational ramifications of each are as follows:

  1. Site specificity. Unified ownership is the preponderant response to an asset specificity condition that arises when successive stages are located in close proximity to one another. Such specificity is explained by an asset immobility condition, which is to say that the setup and/or relocation costs are great. Once such assets are located, therefore, the parties are thereafter operating in a bilateral exchange relation for the useful life of the assets.
  1. Physical asset specificity. If assets are mobile and the specificity is attributable to physical features, market procurement may still be feasible by concentrating the ownership of the specific assets (e.g. specialized dies) on the buyer and putting the business up for bid. Lock-in problems are avoided, because the buyer can reclaim the dies and reopen the bidding should coniraciual difficuhies develop. Thus ex post competition is efficacious and internal  organization  is unneeded.’
  1. Human asset specificity. Any condition that gives rise to substantial human assets in team configurations—favors an employment relation over autonomous contracting. Common ownership of successive staged is thus predicted as the degree of human asset specificity deepens.
  2. Dedicated Assets. Investments in dedicated assets involve expanding ex.sing plant on behalf of a particular buyer. Common ownership in these circumstances is rarely contemplated. Trading hazards are nevertheless recog-nized and are often mitigated by expanding the contractual relation to effect ymmetrical exposure. Paradoxically, greater aggregate hazard exposure can be mutually preferred to less if, as a consequence, hazard “equilibration” is thereby realized. (The issues here are developed more fully in Chapters 7 and 8).

Yet another implication of transaction cost reasoning is that where firms are observed both to make and to buy an identical good or service, the internal technology will be characterized by greater asset specificity than will the external technology, ceteris paribus. No other approach to the study of vertical integration generates this set of implications.

2. Efficient Boundaries 

The foregoing treats every separable stage of production as one for which a careful assessment of make-or-buy is warranted. In fact, matters are often impler than that. There are some stages for which integration is not apt to be seriously considered. Backward integration into raw materials is infeasible for many firms. Moreover, there are other stages for which common ownership wilI appear ,o be natural. James Thompson’s references to a “core tech-nology” (1967, pp.19-23) presumes that some stages will be consolidated specificity is commonly associated with these. More interesting is the procurement of items for which off-site production experiences little or no penalty. When is such a component bought, and when is it made?

All these issues can be pulled together in the context of the “efficient boundaries” problem.39 Thus consider the organization of three distinct pro- duction stages, which, for site-specificity reasons, are all part of the same firm. That is the technological core. Suppose that raw materials are distinct and are naturally procured from the market. Suppose further that two things occur at each production stage: There is a physical transformation, and components are joined to the “mainframe.” And suppose, finally, that the firm has a choice between own distribution and market distribution.

Let the core production stages be represented by S1, S2, S3, and draw these as rectangles. Let raw materials be represented by R and draw this as a circle. Let component supply by represented by C1-B, C2-B, C3-B if the firm buys its components, and C1- O, C2-0, C3-0 if it makes its own components. Draw these as triangles. Let distribution be given by D-B if the firm uses market distribution, and D-0 if the firm uses own distribution. Draw these as squares. Finally, let a solid line between units represent an actual transaction and a dashed line a potential transaction, and draw the boundary of the firm as a closed curve that includes those activities that the firm does for itself.

Given the core technology presumptions, stages S1 through S3 will be organized internally and raw materials will be purchased. Components Cl through C3 and stage D thus remain to be evaluated with respect to the tradeoffs set out in subsection 2.2 above. Assume that the firm determines on this basis to make component C2 and engage in own distribution. The efficient boundary of the firm is thus given by the closed curve in Figure 4-3 that includes, in addition to the technical core, component C2 and the distribution stage, D. Components C1 and C3 and raw material are procured in the market.

Obviously this is arbitrary and merely illustrative. It also oversimplifies greatly. It is relatively easy, however, to elaborate the schema to add to the core, to consider additional components, to include several raw material stages and consider backward integration into them, to break down distribution, and so on. But the central points would remain unchanged, namely: (1) The common ownership of some stations—the core—is sufficiently obvious that a careful, comparative assessment is unneeded (site specificity will often characterize these transactions); (2) there is a second set of transactions in which own supply is manifestly uneconomic, hence market supply is indicated (many raw materials are commonly of this kind); but (3) there is a third set of activities for which make-or-buy decisions can be made only after assessing the production and transaction cost consequences of alternative modes. The efficient boundary is the inclusive set of core plus additional stages for which own supply can be shown to be the efficient choice.

FIGURE 4-3: Efficient Boundary

The basic orientation that informs the transaction cost approach to vertical integration is that integration should be selective. Contrary to what is sometimes argued, more integration is not always better than less. The data bear this out (see Chapter 5).

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

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