Technical Change, Competition and Vertical Integra-tion

Srinivasan Balakrishnan

Birger Wernerfelt

Strategic Management Journal (1986)

by Eunkwang Seo

Session 3: Transaction Costs Application

AGENDA

Research Questions

Why certain investments in the long run would be

more attractive to integrated firms than to

independent suppliers?

Two Explanatory Variables

1) Competitiveness of Market: An integrated firm will do better than an un-integrated

firm if there are less participants and thus high profit in

the value-added chain.

2) Technological instabilities: An integrated firm will do better than an un-

integrated firm if technological changes occur less

frequently in the industry.

1. THEORIES OF VERTICAL INTEGRATION

When is Vertical Integration Desirable? (1)

1) Competitive Considerations Vertical integration may provide competitive advantages

to incumbents by increasing entry barrier (integration

concentration). Transaction cost theory maintains that rent earnings

potential, indicated by a small number of participants,

leads to integration (concentration integration).

2) Production Economies of Integration Because of technological inseparabilities, the transfer

of an intermediate product between successive stage of

production may be costly. However, it is also possible for the separate owners to

locate their plants adjacent to each other and carry out

the transaction under market contracts (Mahoney, 1992).

1. THEORIES OF VERTICAL INTEGRATION

When is Vertical Integration Desirable? (2)

3) Transactional Economies Transactions under a hierarchy takes place because

hierarchies have advantages to reduce transaction

costs under market contracts. As the size and span increases, costs in administering

transactions within the integrated firm also increases

significantly.

4) Technological Instabilities Williamson (1975) argued that uncertainty in general

leads to more vertical integration. For a particular type of uncertainty, such as the

possibility of technological obsolescence, the relationship

does, however, reverse. Because technological innovations wipe out prior

investments, a highly volatile industry characterized by

frequent technological changes will be unattractive for

high levels of integration.

MajorDifference

2. ANALYTIC MODEL

A Simple Model (1)

π : the profit of the down-stream firm

v: the fraction of resources invested in the value-added chain in its industry

s: the firm’s market share in the consumer market

m: the fraction of profit lost in market transactions

b: the fraction of profit lost in bureaucratic transactions

Basically, ps reflects the ‘basic’ level of profitability in the

industry reflecting the entry barriers associated with

integration as as well as the specificity of assets. As vertical integration(v) increases, market transaction costs

(m(1–v)) decrease, but bureaucratic costs (bv) increase.

Profits Costs

A Simple Model (2)

T: the expected time to innovation that will wipe out the investment v

i: the rate of return on the remaining part of the firm’s capital (1-v)

r: the discount rate (r > i)

The negative β1 : The optimal level of vertical integration is

lower in more competitive situations where the firm’s

market share is low.

The negative β2 : Higher technological instability leads to

lower levels of integration especially when market shares are

low.

2. ANALYTIC MODEL

NPV from investment v

Methods

• Research Setting

A sample of 93 SIC-4 digit level manufacturing industries.

Given that p, b, m, r, and i are identical across industries, β0, β1, β2 can be estimated with cross-sectional data.

• Measures

Vertical integration: the proportion of economic

processes carried out within the firm (vertical integration

index)

Competitiveness : the average size of the largest firms

in the industry which account for 50 percent of the total

value of industry shipments.

Technological instabilities: the average age of plant

and equipment

3. EMPIRICAL TEST

Empirical Test• Estimation of cross-sectional model

• Estimation of pooled model (1974, 75, 76)

Estimation

• Results

As predicted, β1 and β2 are shown negative and

statistically significant at the 0.05 level.

The relatively low R2, however, presumably suggests that

other factors contribute significantly to the determination

of integration strategy.

3. EMPIRICAL TEST

DISCUSSION

Technological Instability Leads to Less

Integration?

• Tautology Issue The authors argue that for technological instable industries

integration strategy is less preferred. However, since the authors define technological instabilities

as the frequency of innovations wiping out prior integration

investments, it seems to be tautological (something making

a thing less preferred makes it less preferred).

• Flexibility of Integrated Firms Basically, integrated firms are regarded as less flexible than

un-integrated firms. In my opinion, however, it ALSO

depends on transaction costs in the market. If costs in searching appropriate partners, bargaining their

transactions, and monitoring them are high, integrated firms

that control their in-house behaviors by hierarchy can

become more flexible to environmental changes.