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date: 21 April 2019

Vertical Integration and the Theory of the Firm

This is an advance summary of a forthcoming article in the Oxford Research Encyclopedia of Business and Management. Please check back later for the full article.

While no unified theory of vertical integration exists, transaction cost economics, agency theory, and more recently, property rights theory, have been influential in analyzing not only make-or-buy decisions, but also in understanding “hybrid forms” or interfirm alliances, such as technology licensing contracts, equity alliances, joint ventures, and the like.

Before Coase’s work became widely known, the theoretical underpinnings of vertical integration were provided by the neoclassical theory of the firm. Here, the firm was viewed as a production function that utilized the most technologically efficient way to convert input into output. In particular, neoclassical theory was concerned primarily with market power and the distortions that it created in markets for inputs or outputs as the main driver of vertical integration. Hence, the boundaries of the firm—that is, where to draw the line between transactions that occur within the firm and those that occur outside the firm—were irrelevant within this framework. It was Coase’s question: “Why is there any organization?” that first suggested that price mechanisms in the market and managerial coordination within firms were alternative governance mechanisms. That is, the choice between these alternative mechanisms was driven by a comparative analysis of the costs of implementing either mechanism.

Williamson built on Coase to provide the theoretical foundations for vertical integration by joining uncertainty and small numbers with opportunism in defining exchange hazards, and thus provide a comparative analysis of alternative governance forms. More recently, property rights theory brought attention to ownership of key assets as a way to distinguish between the governance of internal organizations compared to that of market transactions, where ownership confers to the holder of these residual control rights the authority to determine how these assets will be used. Last, agency theory provides important building blocks for understanding contractual choice and, by extension, boundaries of the firm, by placing the emphasis on the different incentives that vary with different contractual arrangements between a principal and its agents.

Transaction cost economics, property rights theory, and agency cost theory complement one another well in explaining vertical integration in terms of alternative governance forms in a world of asymmetric information, bounded rationality, and opportunism.