Vertical Integration: Technological Determinism

Ours is indisputably a technologically advanced society. That complex orga- nization is needed to serve a complex technology is surely common sense. In particular, comprehensive integration—backward into materials, laterally into components, and forward into distribution—is widely believed to be the organizational means by which complex products and services are created, produced, and efficiently brought to market.

That conception is supported by the firm-as-production-function orienta- tion. Large, integrated firms, wherein production is accomplished by joining fungible inputs to yield outputs according to the engineering specifications, are supposedly the rule rather than the exception. Reference to “physical or technical aspects” sometimes buttresses this nonmarket presumption. The standard example is the integration of iron and steel making. Where the realization of thermal economies is said to require integration (Bain, 1958, p. 381). Even, moreover, if tight technological linkages of that kind are missing, existing configurations of assets are widely believed to reflect technological principles. Especially among noneconomists, more integration is thought to be preferable to less. Only in such rare circumstances where outside suppliers have patents or where economies of scale or scope are very large would outside procurement be seriously contemplated.

All of the above is plausible, which is to say that vertical integration appears to be the unproblematic result of a natural technological order. I submit, however, that intermediate product market transactions are much more numerous than the conventional wisdom would suggest.3 The marvels of the market to which Hayek referred in 1945 apply equally today. I furthermore contend that decisions to integrate are rarely due to technological determinism but are more often explained by the fact that integration is the source of transaction cost economies.

One way of putting it is as follows: Technology is fully determinative of economic organization only if (1) there is a single technology that is decisively superior to all others and (2) that technology implies a unique organization form. Rarely, I submit, is there only a single feasible technology, and even more rarely is the choice among alternative organization forms determined by technology.

Recall in this connection the contracting schema in Chapter 1, where general purpose and special purpose technologies are distinguished. Recall further that the parties to the transactions so described have the option of crafting governance structures responsive to their contracting needs. Only as market-mediated contracts break down are the transactions in question removed from markets and organized internally. The presumption that “in the beginning there were markets” informs this perspective.

This market-favoring premise has two advantages. One is that it helps to flag a condition of bureaucratic failure that has widespread economic importance but goes little remarked. (The issues here are briefly introduced in section 3 and are more fully developed in Chapter 6.) Second, it encourages the view, which 1 believe to be correct, that technological separability between successive production stages is a widespread condition—that sepa-rability is the rule rather than the exception.38.It thus becomes easy and even natural to regard the transaction as the basic unit of analysis. As between alternative feasible modes for organizing transactions, which has superior efficiency properties and why? Once that orientation is adopted, internal organization is seen less as a consequence of technology and more as the result of a comparative assessment of markets and hierarchies.

A useful strategy for explicating the decision to integrate is to 4iold technology constant across alternative modes of organization and to neutralize obvious sources of differential economic benefit, such as transportation cost savings. Thus consider two separable manufacturing operations in which the output of one stage feeds the next. An entrepreneur has decided to enter stage II activity and is considering alternative ways of organizing stage I. One possibility is to solicit bids from qualified suppliers to produce to his needs. A second is to integrate backward and do the work himself.

Assume that the same stage I technology will be employed whether the entrepreneur makes or buys. One factor that would appear to favor own- manufacture over procurement is that transportation cost economies may be realized. That is superficial, however, since an independent stage I supplier can locate in the same cheek-by-jowl relation to stage II as can an integrated owner. Accordingly, transportation (and related inventory cost savings) are neutralized. What is it, then, that favors one of the modes in relation to the other?

Although this query is one to which a theory of the firm might reasonably be expected to speak, mundane vertical integration of this kind is a subject on which the orthodox view of the firm as production function is curiously silent. Given that the two stages in question are technologically separable, and given that factor price, tax, and related distortions are not obviously posed, there is no compelling neoclassical reason to prefer integration over market procurement.

The notion that an independent stage I supplier would be willing to locate in cheek-by-jowl proximity to the stage II buyer nevertheless runs contrary to intuition. Surely there are undisclosed hazards in such an association? If so, does this have organizational ramifications?

Note that reference to hazards introduces nonproduction (transaction cost) considerations. Of special importance in this connection, and the distinct contribution of transaction cost economics, is the following proposition: The magnitude of the hazards depends on the attributes of the assets and on the characteristics of the contracting relation.

Thus suppose that stage I requires an investment in durable, general purpose equipment that is mounted “on wheels,” hence can be costlessly relocated. Contractual problems between independent buyer and supplier are here limited since contracts can be terminated and productive resources relo- cated at negligible cost. Given the unspecialized nature of the investments and the mobility that has been ascribed to them, neither buyer nor supplier operates at the sufferance of the other. Problems arise, however, if stage I involves durable specialized investments or if, once put in place, relocation of general purpose assets is thereafter very costly. Here the parties must face issues such as the following: Can the complex contract be written and implemented at low cost whereby independent parties assuredly adapt their relation efficiently to changing circumstances? What are the hazards of incomplete contracting? In consideration of the fundamental transformation to which autonomous con- tracting is subject in these circumstances, ought unified ownership of the two stages be elected instead? Adaptive, sequential decision-making of the combined stages would then be implemented under the administrative aegis rather than in a recurring bargaining context.5

To be sure, this is a highly simplified and stylized example. But the basic argument applies quite generally: Technology is not determinative of economic organization if alternative means of contracting can be described that can feasibly employ, in steady state respects at least, the same technology. I submit that several alternative modes commonly qualify, whence technology is more usefully regarded as a factor that delimits the set of feasible modes— the final choice thereafter turning on a transaction cost assessment. Distinguishing among transactions according to their attributes is essential for final mode selection purposes.

Even that, however, is too simple. It assumes a sequential process whereby technology is selected first and choice among feasible organizational modes is made thereafter. This convenient expository device is used in section 2, below. In fact, however, technology and organizational modes ought to be treated symmetrically; they are decision variables whose values are determined simultaneously. The issues here are addressed elsewhere -(Masten, 1982; Riodan and Williamson, forthcoming). Suffice it to observe that, albeit qualified, the main arguments survive when formulated in a more general framework.

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

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