Edited by Peter G. Klein and Michael E. Sykuta
Chapter 17: Vertical Integration
Peter G. Klein Vertical integration, or the ‘make-or-buy decision’, has been described as the ‘paradigm problem’ of transaction cost economics (TCE) (Williamson, 1996b, p. 65). Indeed, while TCE can be regarded as a highly general approach to economic organization – Williamson (1996b, p. 8) states that ‘any problem that arises as or can be posed as a contracting problem can be examined to advantage in transaction cost economics terms’ – the theory was largely developed in the context of a particular application: organizing the vertical stages of production. When Coase (1937, pp. 393–4) famously asks, ‘[w]hy does the entrepreneur not organise one less transaction or one more?’, he is referring to transactions between the entrepreneur and a factor of production (for example, labour) – a vertical transaction. Why, then, do some firms choose a vertically integrated structure, while others specialize in one stage of production and outsource the remaining stages to other firms? Why are some inputs procured on the spot market, others through ongoing relationships with particular suppliers, yet others through complex supplier networks or alliances? Should a manufacturing firm use its own distributors, or should it contract with independent retailers? Should investment projects be funded on the external capital markets, or should the firm rely on internal finance? Traditionally, economists viewed vertical integration or tight vertical relationships as attempts by dominant firms to earn monopoly rents by gaining control of input markets or distribution channels, to engage in price discrimination, or to eliminate multiple markups along the supply...
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