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date: 17 October 2019

Vertical Integration and the Theory of the Firm

Summary and Keywords

How do firms organize economic transactions? This question can be thought of as a question of firm boundaries or as a decision about a firm’s scope, encompassing the choice along a continuum of governance structures, including spot markets, short-term contracts, long-term contracts, franchising, licensing, joint ventures, and hierarchy (integration). Although there is no unified theory of vertical integration, transaction cost economics, agency theory, and more recently property rights theory have been influential not only in analyzing make-or-buy decisions but also in understanding “hybrid forms” or inter-firm alliances, such as technology licensing contracts, equity alliances, joint ventures, and the like.

Before Coase’s work became widely known, whatever theoretical underpinnings there were of vertical integration were provided by applications of neoclassical theory. 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 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.

Oliver 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 consequently established comparative analysis of alternative governance forms as the way to analyze vertical integration. More recently, property rights theory brought attention to ownership of key assets as a way to distinguish between the governance of internal organizations and those of market transactions, where ownership confers the authority to determine how these assets will be utilized. And lastly, agency theory also provides important building blocks for understanding contractual choice by placing the emphasis on the different incentives that vary with different contractual arrangements between a principal and its agent.

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. These theories have also been utilized in analyzing “hybrid” organizational forms, in particular strategic alliances and joint ventures. Together, vertical integration and alliances account for a significant part of corporate strategy decisions, and more research on the theoretical foundations as well as novel ways to apply these theories in empirical analyses will be productive avenues for a better understanding of firm behavior.

Keywords: uncertainty, asset specificity, information asymmetry, opportunism, ownership, incomplete contracts

Introduction

Vertical integration is usually defined as make-or-buy decisions, where the firm either performs an economic activity itself (“make”) or purchases the results of such an activity from an independent firm (“buy”). Although vertical integration is usually thought of as a binary decision—either make-or-buy or market versus hierarchy—the logic that applies to this dichotomy also applies to the choice along the entire continuum of governance forms. For instance, we can think of full integration, where all of a particular input is sourced in-house, or tapered integration, where only a portion of the firm’s requirement for input is sourced in-house, in terms of whether the businesses along the vertical value chain are wholly owned by the focal firm or not (i.e., quasi-integration) (Harrigan, 1984). More broadly, the vertical integration decision can be thought of as one of firm boundaries or as a decision about a firm’s scope, encompassing the choice along a continuum of governance structures, including spot markets, short-term contracts, long-term contracts, franchising, licensing, joint ventures, and hierarchy (integration).

Vertical integration is one of the most important decisions in business and economics. For one, it deals with alternative means of organizing economic activities along the value chain, with performance implications for the various ways that the value chain can be structured. And more fundamentally, it deals with the question of what constitutes a “firm.” That is, a theory of vertical integration is a theory of the firm.

Our understanding of vertical integration is now centered on the comparative assessment approach that began with Ronald Coase’s (1937, 1960, 1988) seminal works. Prior to Coase (1937), economists conceptualized the firm as a production function that chose the most technologically efficient methods to convert inputs into outputs. This “black box” view of the firm in neoclassical theories meant that vertical integration was often analyzed through the lens of market efficiencies as responses to market power that existed in the upstream and/or downstream markets, and as ways for firms to seek to exploit market power themselves. Take, for example, the case of bilateral monopolies with two firms in successive stages of the value chain, where the seller is a monopolist and the buyer is a monopsonist. Because bargaining between such firms is “indeterminate with a vengeance,” so that setting the optimal (profit-maximizing) quantity of inputs provided and the appropriate price is difficult (Scherer & Ross, 1990), an un-integrated bilateral monopoly situation leads to less than optimal profits. Therefore, vertical integration can make both sides better off by allowing the integrated firm to make production decisions to maximize profits, thus enhancing economic efficiency.

Price discrimination is one of the motives for vertical integration analyzed through the lens of neoclassical theory. Take, for example, an intermediate good monopolist selling to two downstream competitive industries seeking to charge different prices, where the lower prices are charged to the downstream firm with greater price sensitivity. Vertical integration by the upstream monopolist can eliminate the possibility of arbitrage of the intermediate good by the downstream firms (Mahoney, 1992).

There are many other applications of the neoclassical approach—increasing barriers to entry, foreclosing competition to enforce oligopolistic competition, and so forth—for why firms would seek to vertically integrate. The strategy literature has also provided rationales for vertical integration in terms of volatile industry structures (where intense price competition is implied as a result of such volatility) or whether the industry is in an embryonic stage or in a more mature stage (Harrigan, 1984), but it is not my purpose to provide a comprehensive review of that literature here. Although nearly all theories of vertical integration have market imperfections as a starting point, neoclassical theories mostly focus on vertical integration as a response to market power problems or as a way to enhance market power in upstream or downstream markets. In doing so, neoclassical theory treats vertical integration itself as “costless” compared to alternative institutional arrangements; that is, only the costs of market inefficiencies, such as price and quantity distortions, are accounted for, whereas the costs of internal organization are not, so that vertical integration becomes a possible solution for almost any market imperfection (Joskow, 2010). It was Coase (1937) who first argued that markets and firms were alternative governance mechanisms. In particular, the market mechanism was also subject to various transaction costs, and consequently the vertical integration decision has to be analyzed through a comparative assessment of these alternative mechanisms.

This article reviews the theoretical bases for this dichotomy between markets and hierarchies, in particular transaction cost economics, agency theory, and property rights theory. Although the vertical integration decision may be realized as one of a multitude of options along the continuum of governance structures, the theory is most easily understood as the decision between contractual market exchange and internal transactions within the boundaries of the firm. That is, what types of market transactions can be best substituted by activities within the firm (e.g., input or service is produced in-house)? This decision depends on the advantages and disadvantages of vertical integration compared to those of market transactions. This question of organizational forms also encompasses “intermediate” or “hybrid” organizational forms that lie between the two poles of integration and spot market transactions.

Incomplete Contracts

A critical starting point for comparative assessments between “make” versus “buy” decisions is the concept of incomplete contracts. A complete contract specifies all future contingencies as the transaction unfolds and perfectly mitigates contractual breaches so that the contracting parties comply with the terms of the agreement and do not shirk their duties. A complete contract would be what Macneil (1978) refers to as “classical contract law,” where the identity of the transacting parties is irrelevant; the terms of the contract are carefully delimited; and the remedies are narrowly prescribed so that the consequences are predictable and not open-ended (Williamson, 1979).

However, virtually all real-world contracts do not fully specify every contingency. That is, contracts are incomplete in a world of uncertainty, meaning they are silent with respect to unforeseen contingencies. Because contracts do not allow the exchange partners to easily adapt to such contingencies as they arise, disputes can arise between the contracting parties that cannot be easily resolved. For instance, long-term contracts (as opposed to “simple” spot market or short-term contracts1) inherently have gaps in the planning and accordingly have processes in place for dealing with such gaps, such as arbitration procedures (Macneil, 1978). But when unforeseen contingencies arise, one remedy is mutual: follow-up agreements among the contracting parties. This is not easily achieved when the interests of the contracting parties do not align well (Williamson, 1979). For instance, Williamson (1979) suggests that quantity contracts are easier to adjust compared to price contracts, which have more of a zero-sum nature.

Several factors make complete contracting difficult. The costs of writing and enforcing contractual provisions increase when contracting parties are boundedly rational. Also, limitations of language in specifying and measuring performance, such as when tacit knowledge (Polanyi, 1966) is involved, can prevent complete contracting as well. And lastly, asymmetric information can also increase contracting costs.

Bounded rationality is defined as the limited capacity of individuals to process information and deal with complexity. Human behavior is “intendedly rational, but only limitedly so,” and that is when it is possible to have a “genuine” theory of organizations (Simon, 1997), or a theory of the firm. Boundedly rational individuals cannot anticipate nor enumerate every possible contractual contingency in advance. This is because individuals are limited in their knowledge, foresight, skills, computational abilities, and so forth. Therefore, when making decisions that are adaptive and sequential in nature, the (internal) organization serves to make up for such individual limits on rationality.

When products or services of variable quality are traded, measurement costs may be substantial. For instance, Barzel (1982) suggests that warranties are offered for complex electronics products because of the high costs of measuring quality on the part of consumers. In such contracts, defining performance may be subtle and complex, making it difficult for the transacting parties to spell out the rights and responsibilities precisely. Incentive-based pay is a seemingly straightforward response to the high cost of measuring an agent’s effort, as in the case of sales commissions contracts. However, if performance cannot be easily ascertained from output, then it is necessary to observe the process (Barzel, 1982). Moreover, measurement will be carried out by the party who has access to the information necessary, and also for whom the measurement costs are low, thus exacerbating the information asymmetry problem.

Information asymmetry refers to the situation when one contracting party knows something that the other party does not. Even if all possible contingencies are accounted for and measurement problems are controlled for, if there is asymmetric information, there is the potential for one party to distort or misrepresent information. Asymmetric information at the time of initial contractual negotiations is a case of hidden information (Arrow, 1985), and it is referred to as ex ante information asymmetry, or adverse selection (Akerlof, 1970). For example, a seller may have better information than the prospective buyer about the product she or he is selling, putting the buyer at a disadvantage in the negotiations process. Because of adverse selection, insurance companies often find that higher at-risk customers are more willing to pay higher insurance premiums for policies. If the insurance company charges average prices while riskier customers self-select for purchasing insurance policies, the company will eventually pay out more benefits or claims than the premiums it collects from customers.

In contrast, ex post information asymmetry, or moral hazard, is a case of hidden action (Arrow, 1985) and refers to a situation where one party assumes additional risks that negatively impact the other contracting party after the initial negotiations have been completed. That is, one or more of the contracting parties have not entered into the contract in good faith. For instance, if an insurance customer engages in risky behavior after purchasing the insurance policy (behavior that the insured would otherwise not engage in if there were no such insurance policy in place), then such behavior is referred to as moral hazard.

To sum up, because of bounded rationality, measurement problems, and information asymmetry, most contracts are incomplete. However, even if these conditions are present, contract law specifies a set of standard provisions that apply to most contracting situations. Moreover, norms, customs, and other such aspects of social capital matter for contracts (Macaulay, 1963), so the relation becomes like a “minisociety with a vast array of norms” (Macneil, 1978, in Williamson, 1985, pp. 71–72). Indeed, property rights are defined not only by explicitly legal means but also through various social mechanisms (Alchian, 1965).

Litigation is an expensive way to engage in contractual arrangements, and contracting parties that resort to lawsuits may irrevocably damage their own business and reputation because of “overtones of bad faith” (Macaulay, 1963). Therefore, even where contract law does not sufficiently rise to complete contracting, other mechanisms like reputational effects and norms may be effective to a certain extent. However, when the inefficiencies of incomplete contracts are significant—that is, when the transaction costs are large enough—vertical integration may be comparatively more efficient than contracts to organize economic transactions. For one, when one or both transacting parties invest in relation-specific assets, the risk of opportunistic behavior like holdup by the counterpart may exacerbate the problems from contractual incompleteness. Also, when the agent’s level of effort or the agent’s level of investment in non-contractible assets is difficult to verify and enforce, contractual incompleteness may lead to a loss of productivity.

Boundaries of the Firm: Theoretical Foundations

Transaction Cost Economics

The great insight of Coase (1937) is that markets and firms were defined as alternative governance forms, and the key to assessing which governance mode is chosen is the comparative costs of transacting. That is, absent transaction costs, markets and firms are theoretically equivalent. Transaction cost economics (Williamson, 1975) starts with this tautology, and unlike neoclassical theory, the underlying assumption is that contracts are incomplete, and the various elements of the transaction—frequency, uncertainty, and asset specificity (Williamson, 1985)—play key roles in the costs of governing market-based contractual arrangements. The administrative costs of governing the internal organization are the other side of the equation in a comparative evaluation of costs associated with various governance forms.

Of the three elements of transaction costs, frequency is not considered critical for determining choice of organizational form (Mahoney, 1992). In cases of low asset specificity, frequency of transaction does not affect organizational form. In cases of high asset specificity, unified governance is the efficient organizational form regardless of frequency. Hereafter, the focus is on uncertainty, and especially asset specificity, as the key determinant of transaction costs.

Uncertainty has often been cited as an important contributing factor in understanding vertical integration decisions. Indeed, without uncertainty, many interesting problems in economic organization disappear (Hayek, 1945; Knight, 1921), including comparative institutional assessments (Williamson, 1985). Vertical integration may be a way to resolve uncertainty. Several empirical studies (Gil, 2007; Masten, Meehan, & Snyder, 1989; Masten, 1984; Monteverde & Teece, 1982; Woodruff, 2002) suggest that uncertainty is positively associated with vertical integration because uncertainty raises the costs of contracting.2 But uncertainty can take many different forms. For example, as shown in a number of empirical studies, firms may seek to reduce uncertainty in the supply price of an intermediate good and ensure supply, or firms may seek to address fluctuations in the downstream market to mitigate the risk of foreclosure of markets. But a more strategic kind of uncertainty relevant to understanding contracting behavior is at the heart of the comparative assessment of alternative governance choices (Williamson, 1985).

Williamson (1985) considers state contingency uncertainty like demand or technological uncertainty and uncertainty associated with (merely) a lack of communication or asymmetric information to be “innocent” or “nonstrategic,” and instead emphasizes the role of behavioral uncertainty in the vertical integration decision. The limits of bounded rationality are quickly reached when one must deal with the surprise moves and complex responses in economic dealings between potentially opportunistic actors. Therefore, behavioral uncertainty is more relevant than market demand or technological uncertainty for contracting. Moreover, the contracting difficulties are exacerbated when combined with asset specificity.

One of the most critical concepts in transaction cost economics is asset specificity, which is the result of relation-specific investments. Asset specificity means that a firm’s asset has higher value in one particular setting compared to other settings, thus making it difficult to redeploy the asset in a different use without losing economic value. The specificity of an asset can be measured as the amount of investment value that is lost if used outside this specific setting. A special case of specific assets is the case of co-specialized assets (Teece, 1986), where two assets are most productive when used together and lose their value when used separately.

Asset specificity arises in a number of contexts (Williamson, 1985): (a) site specificity, (b) physical asset specificity, (c) human asset specificity, and (d) dedicated assets. Site specificity is when a buyer and supplier locate their facilities next to each other to economize on various costs, such as transportation, inventory, and so forth. Site specificity matters when the asset in question is impossible or prohibitively costly to move. One example of site specificity is a coal plant that is located at a mine mouth (Joskow, 1985). The mine-mouth plant relies on the mine for its coal and would lose much of its value if the mine were to close. Similarly, the mine would also lose significant value if the mine-mouth coal plant, its primary customer, were to close. The mine and the mine-mouth coal plant are both far more valuable if they are co-located, and thus are considered co-specialized assets. The problem here is that the jointly created value depends on the behavior of both parties (i.e., a bilateral monopoly situation)—the mine-mouth coal plant and the coal mine—opening the door to possible opportunistic actions by either party. When the relation-specific investment, such as building the mine-mouth coal plant, can be devalued by the actions of the other party (the owner of the mine), this is referred to as holdup.

Another context where asset specificity may arise is physical asset specificity. This is where the buyer or supplier, or both, make relation-specific investments in the equipment and machinery that involve design characteristics that have lower values in alternative uses. In the classic case of the Fisher Body and General Motors, investments in the tools and dies to produce components that are specialized to this relationship are one example. In the 1920s, General Motors sourced automobile bodies from Fisher Body, but as the technology evolved from wooden bodies to metal, General Motors asked Fisher Body to build a new body plant next to General Motors to ensure reliability. However, Fisher refused, presumably because of the fear that they might become vulnerable to opportunistic behavior by General Motors later on. This situation was eventually resolved when General Motors bought out Fisher Body (vertical integration) (Klein, Crawford, & Alchian, 1978). Similarly, when components are complex and specialized, as in the case of the aerospace industry, vertical integration (in-house production) is more likely (Masten, 1984). As in the case of site specificity, if the component maker invests in the equipment to specifically tailor the component for a specific buyer, then this investment would be devalued by the particular buyer’s opportunistic behavior, such as reneging on the initial deal.

Learning and teamwork are critical parts of human asset specificity. An example of human asset specificity is when design engineers have developed specialized skills in designing a particular type of aircraft or automotive components that are more valuable inside a particular relationship than otherwise (Masten, 1984; Masten et al., 1991; Monteverde & Teece, 1982). Workers who have accumulated such human capital can produce products and services more efficiently than those who have not built up such relation-specific human capital. At the same time, human capital is often context specific, such as learning company-specific software or a company’s culture and organizational routines. And as such, human capital may lose much of its value when applied in a different context, such as when the employee moves to another company.

Lastly, dedicated assets refer to investments in facilities or equipment to be customized to a specific buyer. This kind of investment is made in generalized production capacity that would not have been possible without the promise of selling the product to a specific buyer.

Asset specificity is important because the need to invest in relation-specific assets transforms a transaction where there are many sellers and many buyers into a transaction that is close to a one-to-one transaction, or a bilateral monopoly. Williamson (1985) refers to this shift from a “large numbers” bargaining situation into a “small numbers” bargaining situation as the “fundamental transformation.” Asset specificity and the fundamental transformation have significant consequences for bargaining and therefore have implications for the costs of governance.

To better understand the central role of asset specificity in determining the magnitude of the transaction costs, the concept of rents and quasi-rents must be understood first. Rents are the portion of earnings in excess of the minimum amount necessary for a firm to enter an industry or the minimum required for a worker to accept a job. Quasi-rents are the portion of earnings in excess of the minimum amount that the firm needs in order to stay in the industry or for the worker to not quit his or her job. This is an important distinction; rents are the earnings to attract a firm to enter a market or to attract a worker to take a job, whereas quasi-rents are the earnings to prevent the firm from leaving the market or to prevent a worker from quitting. Therefore, the minimum required earnings in the former must exceed the average total cost, whereas the minimum required earnings in the latter need only exceed the average variable cost. In competitive markets, rents are difficult to sustain, whereas quasi-rents exist whenever there are investments made in specialized assets that are not easy to salvage (i.e., have low alternative value) (Milgrom & Roberts, 1992).

If an asset is not relation-specific, then the quasi-rents accruing from that asset are zero. That is, quasi-rents are positive only if an investment in a relation-specific asset is made. Firms that make such investments do so in order to benefit from the technical efficiencies gained from deploying specialized assets rather than generalized ones. For instance, if a supplier modifies its equipment (i.e., dedicated assets) to produce customized components for its buyer in anticipation of higher prices from the buyer, that supplier is now dependent on whether the buyer does in fact source the specialized components at a higher price than the generic components. The supplier that made the investment to modify its equipment is exposed to opportunistic behavior by the buyer, who might threaten to source generic components unless more favorable terms are renegotiated. This difference between the first-best alternative (e.g., sell specialized components at a higher price) and second-best alternative (e.g., sell specialized components at market price, which is the price of generic components, thus negating the potential for accruing benefits from specialized investment) that the investing firm stands to lose are the quasi-rents. Asset specificity or co-specialization of assets can lead to a holdup problem, and the magnitude of quasi-rents is an indicator of the extent of the risk borne by the firm that is investing in specialized or co-specialized assets.

Holdup by itself does not change the overall value of the specialized or co-specialized assets, but it will have distributional consequences between the buyer and the seller of that asset in the transaction. The Coase Theorem suggests that in the absence of transaction costs, the buyer and seller will come to some appropriate agreement that maximizes the value of the asset. But if transaction costs are significant, one or both transacting parties will anticipate holdup and choose not to invest in relation-specific assets that will expose it to the risk of holdup; seek to invest additional resources into safeguarding the relation-specific investments; contribute to ongoing distrust between the parties; and other such activities that ultimately devalue the transaction.

To summarize, real-world contracts are inherently incomplete. If contracts are complete, then the contracting parties must be able to anticipate all possible contingencies and unambiguously determine the course of action for each possible contingency. Furthermore, the contract has to be mutually verifiable and enforceable. In a world of uncertainty, people cannot foresee all possible contingencies, but rather are boundedly rational and have computational limitations. Furthermore, transacting parties do not necessarily work from the same set of information. As a result, in many economic transactions, the costs of measurement are significant, particularly if performance is subjective or if there are multiple tasks involved (Holmström & Milgrom, 1991, 1994). Norms, conventions, and reputation effects (Hart, 2001; Kreps, 1990) can help frame the relationship so that the parties can agree on broadly applicable parameters and adapt as unforeseen contingencies arise. However, adverse effects of incomplete contracts become amplified when there is significant uncertainty, and even more problematic when there is significant asset specificity. The presence of asset specificity implies that there are quasi-rents that can be held up by a transacting partner. This potential for holdup raises the costs of market transactions because the transacting parties now have to contend with more extensive contracts, face the need to install safeguards to improve the ex post bargaining position, and the like. Transaction cost economics logic suggests that a potential remedy for this situation is vertical integration by bringing such a transaction “in-house.”

The question that arises from this is this: What is integration? That is, how does integration resolve these contractual problems, such as holdup? Also, in this particular situation, if indeed vertical integration is the more efficient governance mode, then who should be the owner? That is, when common ownership between a buyer and a seller makes sense, should the buyer acquire (integrate) the seller, or the other way around?

Property Rights Theory

The vertical integration decision is a choice between the internal organization (integration) and market contracting. The theoretical foundations for this question about firm boundaries were established by Coase (1937), Williamson (1975), and Klein et al. (1978), where the key conceptual building blocks like incomplete contracts, asset specificity, quasi-rents, and holdup were introduced as a part of the comparative assessment framework of alternative governance mechanisms, that is, the price mechanism and integration. But what exactly is meant by “integration”?

According to the property rights perspective, integration is distinguished from market transactions in terms of who owns the assets that create value in the production process, but it does not eliminate activities or resources (including people) from that production process. The choice between alternative mechanisms is efficiency oriented, meaning that there are performance implications depending on different types of governance mechanisms employed. But the question still remains as to why integration has certain characteristics that impact the performance of the production process in a different way from market transactions.

In transaction cost economics, it is argued that the price mechanism of the markets (sales contracts) is replaced with managerial control, or authority, in internal organizations (employment contracts). Alchian and Demsetz (1972) suggest that the key distinction between the sales contract and the employment contract is the question of technological non-separabilities. If not for non-separabilities, the two alternatives—sales contracts and employment contracts—are essentially the same. Non-separabilities matter because measuring the marginal productivity of individual workers in a team production setting is difficult. Williamson (1975) argues that information impactedness and opportunism are also required in order to explain the need for internal organizations to substitute for price mechanisms. Citing Simon (1951), Williamson (1975) argues that sales contracts are inferior to incomplete employment contracts when it comes to adapting to future contingencies (“agree to agree later”). Additionally, Masten (1988) notes that, in practice, employment contracts are treated differently from sales contracts by the law. That is, the law recognizes that employment contracts give the boss the right to make decisions at a later point in time, and the worker accepts the boss’s authority within bounds, or the “area of acceptance” (Barnard, 1938; Simon, 1951). The boss has the authority to give directions and has discretionary authority within this “area of acceptance,” which is the subset of contingencies that have not been specifically laid out at the time of when the contract is written.

Property rights theory, developed by Grossman and Hart (1986) and Hart and Moore (1990), offers many insights that complement transaction cost economics (and as will be discussed later, agency theory). It has even been suggested that the property rights approach is a formalization of the transaction cost economics logic. Both property rights theory and transaction cost economics operate in a world of incomplete contracts and have relation-specific investments and quasi-rents at the heart of the respective theoretical logics, at least as far as the vertical integration decision is concerned. Most prominently, property rights theory and transaction cost economics both predict that in a world of incomplete contracting, increase in quasi-rents is associated with the likelihood of vertical integration (Whinston, 2003). However, there are some important differences.

First, unlike in transaction cost economics, where opportunism is mitigated by internalizing the transaction (vertical integration), from a property rights perspective, it is not necessarily a given that contracting parties become less opportunistic under integration, nor is it automatic that the informational structure changes as a result of integration (Hart, 1995). Property rights theory offers a theoretical basis for how going from a contractual relationship (sales contract) to integration (employment contract) changes the incentives between the contracting parties. To do so, property rights theory focuses on ownership and control over the firm’s physical and intangible assets (i.e., intellectual property, know-how, etc.) because ownership confers the legal authority to determine how the assets will be deployed. According to the property rights theory of the firm, integration matters because it determines who gets to control assets, make decisions, and allocate the profits that result from the production processes. When the firm that should not have ownership (and control) has it, then efficiency suffers because of poor incentives and lack of expertise or capabilities in deploying the assets to their most productive use.

Ownership is a complicated concept. When a person owns an asset, she or he has certain rights and obligations associated with its use. Take owning a car, for example. Owners of cars can drive the car and park the car as they please. They can choose to smoke in the car or upgrade the audio system in the car. They can even allow another person to use the car by transferring these rights either for a short while (rental) or permanently (sale). But owners also have to obey traffic laws, cannot park where prohibited, can only allow a licensed driver to drive their car, and so forth. That is, ownership over an asset comes with certain constraints, whether they are from specific laws, regulations, or societal norms (Alchian, 1965). And more importantly, it raises the question of what ownership is. The person who is renting the car can drive the car and do many of the other things that one might associate with car ownership, but is not the legal owner. Various aspects of property rights over a car can be separately allocated to different people. That is, the asset (in this case the car) is a bundle of property rights, and different people can own different aspects, or partitions of property rights (Alchian, 1965). Then who is the owner? According to the property rights theory of the firm, ownership is defined as residual rights of control (Grossman & Hart, 1986). It is worth noting that Simon’s (1951) “area of acceptance” is analogous to residual rights of control in that this is the aspect of the contract that is initially unspecified but allocated to the boss (owner). To continue with the example, the person who rents the car can use the car within prescribed limitations in the rental contract. However, the aspects of the contract that are silent, where the property rights are not explicitly spelled out, are the residual control rights. Whoever can decide what to do with the car in such situations is the owner, whereas the renter is restricted to only what is allowed contractually (Grossman & Hart, 1986).

As a hypothetical, consider a situation where the transacting parties can foresee all possible contingencies perfectly, and can verify and enforce the provisions accordingly. This is a situation of complete contracts. In such a situation, there would be no unforeseen contingencies—that is, there would be no situation where the contract is silent on how to verify and enforce the agreement. Moreover, there would be no such things as residual control rights because all possible control rights have been defined and allocated in the complete contract, and therefore this notion of ownership would be meaningless. This is a restatement of the Coase Theorem (Coase, 1960, 1988): when transaction costs are zero, ownership does not matter. And the corollary would be that in a world of incomplete contracts, ownership matters for the comparative assessment of governance choice.

To summarize the notion of ownership as residual control rights, consider two firms, firm S and firm B. Firm B is contemplating a decision to either rent a machine that is necessary for its production operations or to buy it outright. If firm S owns the machine and rents it to firm B, then firm S retains the residual control rights to the machine. Let’s further assume that the machine breaks down, and the contract is silent about how quickly firm S has to repair the machine. Because this aspect of the machine’s property rights is not specified in the contract, firm S has the discretion to set the timeline for repair, even if it means that firm B suffers losses in the meantime. If firm B were to acquire the machine outright, then the residual control rights now rest with firm B, meaning it is within firm B’s discretion to set the schedule for repairs rather than waiting on firm S. Moreover, once firm B has ownership over the machine, it now has the incentive to learn specifically about the machine in order to operate and repair it more effectively (a kind of relation-specific investment in that the effort in learning will not easily transfer to another such machine) (Mahoney, 2005).

Second, although transaction cost economics logic is useful for predicting whether a transaction should be carried out over the market or through a hierarchy, it does not make predictions about whether the buyer should backward integrate or whether the other party, the seller, should forward integrate. That is, transaction cost economics logic can tell us whether the buyer and seller should be one firm or two separate firms, but not whether it is the seller that controls or the buyer that controls. Property rights theory provides a theory of which party, for instance, the buyer or the seller, should own the asset.

Property rights logic suggests that it is most economically efficient that the owner of the asset be the one who can utilize the asset most effectively and therefore can gain the most by making decisions specifically about how the asset is deployed. By allocating ownership rights (i.e., residual control rights) to the party who has the most to gain (and the most to lose) from how the asset is deployed, it is possible to ensure that the one who has stronger incentives to deploy the asset in its most productive use also has the ownership rights. That is, the incentives are aligned with ownership of the asset in question.

An important reason for the difference between transaction cost economics and property rights theory, in spite of the many similarities, is that although transaction cost economics focus on the ex post haggling and maladaptation costs arising from investing in relation-specific assets, property rights theory tends to be more interested in the distortions in the ex ante incentives to invest in relation-specific assets. Moreover, although property rights theory assumes that integrated asset ownership (e.g., vertical integration) changes incentives, it does not mean that there are coordinated investments as in transaction cost economics (Whinston, 2003). In this way, property rights theory shares some common threads with agency theory, where the emphasis is on the ex ante incentives to induce effort where measurement costs are high (i.e., effort is difficult to observe). At the same time, one criticism of property rights theory (and this applies to agency theory as well) in understanding the vertical integration decision is that after setting incentives ex ante, not enough attention is given to changes in the organizational features where managers develop monitoring and incentive structures within the firm to increase organizational effectiveness (Joskow, 2010).

Agency Theory

The agency relationship, or the principal-agent relationship, exists whenever one contracting party depends on the actions of another. The party taking the action is referred to as the agent, and the party that is affected by that action is the principal. Whenever the principal cannot perfectly and costlessly monitor and enforce an agent’s actions, agency costs are incurred in order to get the agent to be compliant with the principal’s objectives. For instance, the executive of a corporation has a fiduciary duty to maximize the wealth of the corporation’s shareholders. In this case, the executive is the agent, and the shareholders of the corporation are the principals. This same executive is also the principal when seen in the executive’s relationship with subordinate employees within the corporation, who are the agents working on behalf of their principal, the executive. The executive’s performance is partially dependent on how well the employees carry out their tasks within the corporation.

In principal-agent relationships, such as between a corporate executive and the shareholders of the corporation, or between a worker and the firm, uncertainty and risk make monitoring an agent’s behavior difficult. Therefore, the employment contract has to make an appropriate level of trade-off between providing incentives to the worker (agent) to make maximum effort while not increasing the risk too much. The firm provides the worker with insurance against risk while the market provides high-powered incentives, and the decision on the scope of the firm balances these two opposing forces (Lafontaine & Slade, 2007). The worker receives fixed wages that do not fluctuate (in the short-run) with firm performance, but the independent contractor who does similar tasks receives pay that fluctuates with performance and receives the profits that remain after the variable costs have been paid. As far as their respective output levels are concerned, the worker’s incentives within the firm will be low-powered as a result, whereas the contractor will have high-powered market incentives.3

The principal wants to devise a contract that maximizes agent effort. An important assumption in agency theory is that the principal is risk-neutral, whereas the agent is risk-averse (Joskow, 2010). This is important because if agent and principal are both risk-neutral, the optimal contract might be to have the agent bear the risks so that the agent is fully accountable for his or her performance. In such a set-up, information asymmetry would not matter (Mahoney, 2005). But with risk, information asymmetry exacerbates the difficult task of writing an efficient contract that balances maximizing agent effort (incentives) with insurance (risk reduction). That is, the efficacy of measuring output compared to that of measuring behavior (input) needs to be balanced in order to achieve compliance. Indeed, most agency relationships will likely be a mixture of both types of controls (output and behavioral) in varying degrees (Hennart, 1993). Information asymmetry causes two different types of problems: hidden action (i.e., moral hazard) and hidden information (i.e., adverse selection) (Arrow, 1985).

Hidden information is when the agent has made some observation in making decisions, but the principal has not made this same observation and cannot observe whether the agent is appropriately using this information from his or her own observation to best serve the principal’s interests (Mahoney, 2005). The hidden action problem has to do the agent’s effort once there is a contract in place. For instance, employment contracts are typically designed with the intent of reducing the problem of hidden action, where the employees’ effort level and abilities are difficult to observe. Furthermore, agents are typically more knowledgeable about their tasks than the principals. This hidden action problem relating to agent effort means that there are monitoring costs associated with incentive contracts, and these contracts are effectively incomplete. Alchian and Demsetz (1972) argue that firms exist as a way to measure this effort more effectively.

Agency theory has implications for vertical integration. Similar to property rights theory, if the importance of the agent’s effort to performance increases—that is, if the marginal productivity of the agent’s effort is high—then integration is not likely. The costs of monitoring will be very high, and therefore integration is not an efficient way to get the most productivity out of the agent’s actions, but rather providing high-powered incentives by shifting the risk to the agent will be more effective. Less integration suggests that the agent has more residual claims to the returns to his or her productivity. But if the agent’s risk aversion is significant enough, then such high-powered incentives may be counterproductive, and integration becomes more likely because the agent will prefer low-powered incentives and insurance from the risk.

Because of information asymmetry, particularly hidden action problems between agents and principals, monitoring costs associated with incentive contracts are significant. The predictions about vertical integration in the model of monitoring and incentives is greatly complicated by a number of additional factors. For example, the information asymmetry problem in team production situations with multiple agents leads to the non-separability problem (Alchian & Demsetz, 1972; Holmström, 1982), where measuring marginal productivity is difficult. As non-separability makes monitoring more difficult, vertical integration is likely to be preferred to market transactions because multiple agents coordinating within the firm will be more desirable than those same agents interacting across firm boundaries. Second, because information is unevenly distributed between agent and principal, task programmability—knowledge of the production process—is another consideration that exacerbates the information asymmetry problem in the vertical integration decision. Low task programmability reduces the effectiveness of the monitoring of the agent by the principal (Eisenhardt, 1985; Mahoney, 1992). Accordingly, low task programmability makes monitoring less effective, suggesting that vertical integration is more likely. And lastly, designing a reward system that provides incentives for multiple tasks (Holmström & Milgrom, 1991, 1994) complicates the contract significantly. The added complexity of multiple tasks where different rewards are required for different tasks, and where some of these rewards may even conflict with one another, makes it difficult to design a system of high-powered incentives. When it is difficult to design a reward system that provides the appropriate incentives for the appropriate tasks, integration is the likely solution as firms can employ subjective performance measurements instead of explicit (high-powered) incentives.

Hybrid Forms: Strategic Alliances and Joint Ventures

Although it is beyond the scope of this review to discuss in great detail hybrid organizational forms such as strategic alliances and joint ventures, it seems important to note that the theories reviewed here have been utilized to answer questions regarding the choice of hybrid organizational forms as well. In fact, the vertical integration, or “make-or-buy” decision, deals with two opposite poles along a continuum of organizational forms, and most real-world adaptive responses are some mixture of “market” and “hierarchy” (Hennart, 1993), such as strategic alliances and joint ventures, as well as tapered integration (Parmigiani & Mitchell, 2009), where, for example, a firm sources some of the volume via in-house production and some via outsourcing. Of particular interest is how what we define as in-house transactions (“the firm”) is a mixture of both the price mechanism and the hierarchy mechanism (but with much more emphasis on the latter), while what we define as outsourcing is also a mixture of both mechanisms with a different emphasis (more price mechanism than hierarchy) (Hennart, 1993). The emphasis of the theories of the firm—specifically transaction cost economics, property rights theory, and agency theory—is often seen as being on market failures or frictions. Indeed, market frictions are a reason that firms exist (and why firms are able to generate economic rents) (Mahoney & Qian, 2013). However, this has meant that market failures are emphasized at the expense of organizational failures. As Libecap (1989) convincingly demonstrates in a variety of economic contexts, government failure (or a failure of public policy) is as prevalent, if not more so, than market failures (the failure to write efficient contracts in spite of the potential for great economic gains).

A prominent hybrid or quasi-integration organizational form is the strategic alliance. Strategic alliances have been utilized as a way to pool complementary resources without sacrificing autonomy. When the transaction is quite complex, such as when intellectual property is difficult to protect in technology licensing agreements, firms may engage in alliances. Alliances fall somewhere in between arm’s length market transactions and integration, and involve contractual arrangements as well as sometimes involving an equity stake in the partner firm. Joint ventures also fall under the broad category of organizational forms that are referred to as alliances. In joint ventures, partner firms jointly create an independent legal entity by pooling resources (financial, physical, human, etc.). The term “alliance” is broadly used to include long-term contracts like licensing agreements, and even joint ventures in some cases, although (equity) joint ventures could be categorized more accurately as a joint integration (as the parent companies are all “acquiring” ownership shares in the joint venture entity) (Hennart, 1988).

Alliances can embody some of the more desirable characteristics of both market transactions and vertical integration, but they can also suffer from some of the drawbacks of these organizational forms. The potential exchange hazards that exist in spot market contracts, such as leakage of proprietary information, adapting to unforeseen contingencies, and so forth, also exist in alliances. This is because alliances are formed in order to benefit from enhanced coordination between the firms, exchange of fine-grained information, and many others, but alliances are governed by relatively loose structures compared to unified hierarchy under integration. At the same time, alliances can also suffer from some of the drawbacks of integration, such as the loss of high-powered incentives, which means that the alliance parties may incur the administrative costs of managing the relationships.

As an organizational form that sits between “make” and “buy,” within the “swollen middle” (Hennart, 1993), the theoretical foundations that have been utilized for vertical integration decisions have been adapted to research on alliances and joint ventures (Adegbesan & Higgins, 2010; Baker, Gibbons, & Murphy, 2008; Balakrishnan & Koza, 1993; Deeds & Hill, 1998; Dyer, 1997; Hennart, 1988; Kim, 2011; Lerner & Malmendier, 2010; Lerner & Merges, 1998; Oxley, 1997; Pisano, 1989; Reuer & Ariño, 2007). Although alliances are mostly defined in terms of (usually) bilateral relationships, sometimes involving equity stakes between the alliance partners, joint ventures are independent entities formed separately from two or more partnering firms, and as such can be considered closer to integration, or even “joint integration” (Hennart, 1988), where the partnering firms are effectively jointly acquiring a third-party entity. It is worth noting that this literature has added to our understanding of the theory of the firm and vertical integration by looking at informal governance mechanisms like norms and “trust.” Building on the notion of informal contracts, a great deal of research has been done on how the informal governance mechanisms interact with formal mechanisms in the context of strategic alliances.

Informal governance can be defined as a common understanding between alliance partners about future contingencies that leads to some level of assurance that certain pre-specified actions will likely be carried out. Such relational perspectives (as opposed to the more transactional perspectives from the conventional theories of the firm) are enriching our understanding of inter-firm governance forms.4 The enforcement of such expectations may arise from relational norms or social obligations between exchange partners (Granovetter, 1985; Macaulay, 1963) or from some form of credible commitment or exchange of hostages (Ahmadjian & Oxley, 2005; Williamson, 1983). Many studies have argued that contractual (formal) mechanisms tend to crowd out, or make less effective, informal governance mechanisms such as relational norms (Fehr & Gachter, 2002; Ghoshal & Moran, 1996). This stream of literature suggests that informal governance mechanisms like relational norms and “trust” do not only substitute for formal governance mechanisms (Gulati, 1995; Larson, 1992; Puranam & Vanneste, 2009; Reuer & Ariño, 2007); some advocates go so far as to argue that formal contracts may even undermine the development of informal governance mechanisms such as “trust” (Ghoshal & Moran, 1996).

Others have argued that formal and informal governance mechanisms may also be complementary in some situations (Luo, 2002; Poppo & Zenger, 2002). Informal governance may have a role that facilitates cooperation between the contracting parties. Such an argument suggests that governance mechanisms serve dual roles: control and coordination (Kim, 2014; Luo, 2002; Malhotra & Lumineau, 2011; Mellewigt, Madhok, & Weibel, 2007). Complex relationships require governance structures that reflect the complexity of the task environment. However, this often necessitates complex contracts that are not only costly to write but may also engender suspicion and distrust. That is why there is sometimes ambiguity in contracts that allows for flexibility in an uncertain future (Bernheim & Whinston, 1998). Where the contractual relationship is characterized by a certain amount of ambiguity and a need for flexibility in adaptive responses, informal (self-enforcing) governance mechanisms may be an effective way to safeguard the transaction, thus requiring a combination of formal and informal governance mechanisms (Poppo & Zenger, 2002). Indeed, when the alliance requires mutual adaptation because of the complex interdependencies, development of knowledge-sharing routines and combining of complementary parts across firm boundaries (between the contracting parties) become possible (Dyer & Singh, 1998). In such an instance, mutual learning and co-evolving of each of the alliance partners’ capabilities is likely to be an important path toward joint value creation.

Conclusions

There is no single unified theory of vertical integration, perhaps because it is a multifaceted phenomenon that goes beyond just “make-or-buy” or “outsourcing” decisions. The different theoretical approaches address different types of contractual hazards that lead to non-market organizational forms (Chi, 1994), one of which is vertical integration. Therefore, this review seeks to provide an overview of the theoretical underpinnings of vertical integration from an organizational economics perspective (Mahoney, 2005; Ouchi & Barney, 1986; Rumelt, Schendel, & Teece, 1991). In this review, the focus is on the “efficiency branch” of contracts (Williamson, 1985), namely, transaction cost economics, property rights theory, and agency theory. This branch of theories (contrasted with what Williamson referred to as the “monopoly branch”) owes its common intellectual debt to Coase (1937), whose profound insight was that the theory of the firm (of which vertical integration is but one aspect) should be seen through the lens of comparative assessment of governance forms. These theoretical approaches have had significant empirical support in the literature (Lafontaine & Slade, 2007; Macher & Richman, 2008; Shelanski & Klein, 1995), enhancing our understanding of vertical integration decisions, some criticisms notwithstanding (Carter & Hodgson, 2006; David & Han, 2004; Moran & Ghoshal, 1996).

Even within this efficiency branch of theories of the firm, variations exist in the kinds of empirical phenomena that are addressed, in addition to different theoretical emphases on various contractual hazards. The different theoretical points of emphasis discussed in this review lead to different empirical points of emphasis. Most interestingly, many of the empirical studies that utilize agency theoretic or property rights reasoning tend to examine firms’ (mostly manufacturers’) decisions to forward integrate into retailing, whereas empirical studies on backward integration, such as the classical “make-or-buy” sourcing decisions, tend to utilize transaction cost reasoning (Lafontaine & Slade, 2007). The backward integration contexts tend to emphasize the need to mitigate ex post opportunism by assuring that the investment in relation-specific assets will be safe. In the forward integration contexts, the focus is on getting the ex ante incentives right so as to minimize the costs of monitoring and thereby ensure economic efficiency of the contract. Of the two theoretical perspectives that emphasize ex ante incentives, property rights theory is different from agency theory in that it pays more attention to asset ownership as an important distinguishing feature of behavior within the firm as opposed to across firm boundaries, whereas agency theory makes no such distinction and deals with the problem of writing and enforcing efficient contracts, regardless of firm boundaries.

Beyond vertical integration, it seems important to note that transaction cost economics, property rights theory, and agency theory have been utilized to answer questions regarding the choice of hybrid forms (Hennart, 1988; Oxley, 1997) as well as horizontal integration (Silverman, 1999; Teece, 1980, 1982). In fact, many economic activities carried on along multiple stages of the value chain are some mixture of “market” and “hierarchy” (Hennart, 1993), such as strategic alliances. If we include these hybrid forms of organizing economic activities in addition to vertical integration, many of the business phenomena in today’s dynamic market environment can be studied utilizing the theoretical perspectives discussed here. By advancing our understanding of vertical integration, we can leverage this knowledge to explore many other interesting organizational forms as well.

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Notes:

(1.) If “simple” contracts deliver the feasible outcome desired by the contracting parties, then such a contract will be considered complete (Tirole, 1999).

(2.) It is worth noting that if uncertainty can be indexed (e.g., if a contract is indexed to the price of an underlying raw material), then uncertainty is not necessarily associated with vertical integration.

(3.) It is worth noting that the employee has “high-powered” incentives to engage in appropriate behavior within the firm, whereas the contractor has “low-powered” incentives as far as the kind of appropriate or expected behavior is concerned.

(4.) Gupta (2011) cautions against taking on a purely relational view, and suggests a balance between transactional and relational perspectives is desirable.