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Adaptation in Vertical Relationships

Adaptation in Vertical Relationships

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Published by: Henry Dong on May 01, 2009
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Strategic Management Journal
Strat. Mgmt. J.
,
26
: 415–440 (2005)Published online 11 March 2005 in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/smj.458
ADAPTATION IN VERTICAL RELATIONSHIPS:BEYOND INCENTIVE CONFLICT
RANJAY GULATI,
1
* PAUL R. LAWRENCE
2
and PHANISH PURANAM
3
1
Kellogg School of Management, Northwestern University, Evanston, Illinois, U.S.A.
2
Harvard Business School, Harvard University, Boston, Massachusetts, U.S.A.
3
London Business School, University of London, London, U.K.
 In this study, we extend the analysis of adaptation in theories of economic organizationbeyond traditional considerations of incentive conflict (hold-up). We conceptualize adaptation ascoordinated and cooperative response to change, and define the adaptive capacity of a verticalrelationship as the ability to generate coordinated and cooperative responses across procurer and supplier to changes in procurement conditions. We draw on the concepts of differentiationand integration to dimensionalize the adaptive capacity of different modes of procurement. Usingdata on all component classes procured internally and externally by Ford and Chrysler, we showthat different procurement modes differ in terms of their adaptive capacity and performance. Wealso show that performance differences across modes of procurement arise as a function of thematch between adaptive capacity and adaptation requirements associated with the exchange,and not only the match between governance form and transaction hazards.
Copyright
2005John Wiley & Sons, Ltd.
INTRODUCTION
Vertical (procurement) relationships have alwaysbeen the favorite empirical domain of theoristsof economic organization (Coase, 1937; Gross-man and Hart, 1986; Williamson, 1975). Suchrelationships involve exchange between adjacentstages of the value chain, and they occur bothwithin firms (e.g., between different functional ordivisional areas within a firm) and between firms(e.g., between specialist design firms and special-ist manufacturers). In recent years, the study of vertical relationships has come to be dominatedby transaction cost economics (see Shelanski andKlein, 1995; David and Han, 2004, for reviews).
Keywords: coordination; organization design; differenti-ation and integration; auto industry
Correspondence to: Ranjay Gulati, Kellogg School of Manage-ment, Northwestern University, Jacobs Center, 2001 SheridanRoad, Evanston, IL 60208-2001, U.S.A.E-mail: r-gulati@kellogg.northwestern.edu
In Oliver Williamson’s development of the theory,the focus is on ‘how parties engaged in a long-term contract can adapt effectively to disturbances.The need to craft contractual structures in whichthey have mutual confidence
...
’ is the key issue(Williamson, 1991b). Williamson also notes thatin addition to incentive conflict, failures of adap-tation may arise ‘because autonomous parties readand react to signals differently, even though theirpurpose is to achieve a timely and compatiblecombined response’ (Williamson, 1991a). Yet, thistheoretical recognition of adaptation problems thatmight persist even in the absence of incentive con-flict finds scant recognition in most prior researchmotivated by transaction cost economics.
1
In this
1
We focus on transaction cost rather than property rights whendiscussing existing literature on the economic organization of vertical relationships. This is because the empirical strategy andmanagement literature on vertical relationships is much moreinfluenced by transaction cost economics than property rightseconomics (see Novak and Eppinger, 2001, for an exception).
Copyright
2005 John Wiley & Sons, Ltd.
Received 1 March 2000Final revision received 10 November 2004
 
416
R. Gulati, P. R. Lawrence and P. Puranam
study, our goal is to broaden the conceptualizationof constraints to adaptation in vertical relationshipsbeyond incentive conflict to include constraintsarising from limited responsiveness to changingexchange conditions and coordination failures.The central and most investigated propositionin transaction cost economics concerns a class of adaptation problems resulting from the potentialfor hold-up in vertical relationships (David andHan, 2004; Masten, 2002; Shelanski and Klein,1995). When procurement must be supported bydedicated (relationship-specific) investments, theanticipated costs of the transaction increase. Thisis because dedicated investments by one party cre-ate scope for the other to renegotiate the contractopportunistically when circumstances change. Byorganizing such transactions under common own-ership, muted incentives, enhanced monitoring,and the threat of sanctions can limit opportunis-tic behavior and facilitate cooperative adaptation(Williamson, 1985). However, we will argue inthis paper that adaptation failures in vertical rela-tionships can also occur for reasons other thanhold-up (or concerns about hold-up). Even whenthere is no incentive conflict, bounded rationalitycan cause the parties to an economic relationship tofail to recognize profound changes in the economicenvironment, or generate a coordinated responseto such changes (Camerer and Knez, 1996, 1997;Foss, 2001; March and Simon, 1958). The theoret-ical challenge is to analyze these aspects of adap-tation in addition to traditional hold-up concernswithin a parsimonious and integrated framework.Along the lines of Williamson (1991a, 1991b)we define the adaptive capacity of a verticalrelationship (within or across firm boundaries) asthe ability to generate coordinated and cooperativeresponses across procuring and supplying unitsto changes in exchange conditions. However, ourapproach is distinctive from most prior empiricalresearch in that in addition to the traditional focuson cooperation as the key aspect of adaptation,we also emphasize responsiveness to change andcoordination of responses among the parties.We draw upon some of the seminal researchon organization design to analyze our broaderconception of adaptation in procurement activities.We assess the adaptive capacity of different modesof organizing procurement using the concepts of differentiation and integration. In prior literatureon organizations, these concepts have been usedto formulate principles for designing subunitswithin organizations that could adapt to change(Daft, 2001; Lawrence and Lorsch, 1967a, 1967b;Nohria and Ghoshal, 1994). In this tradition,organizational performance was argued to dependon the match between environmental contingenciesand the extent of differentiation and integrationacross organizational subunits.We extend this analytical approach to verticalrelationships both between and within firms. Weargue that different modes of procurement—make,buy, and ally—differ in terms of the extent of differentiation and integration between procuringand supplying units and therefore in their adaptivecapacity for responding to changes in the exchangeenvironment in a coordinated and cooperativemanner. We therefore expect that the performanceof a given procurement activity will dependon the match between the adaptive capacityof the specific mode of procurement and theneed for adaptation in the specific exchangerelationship that is in turn impacted by contextualfactors associated with the exchange. We testthis prediction through a switching regressionmodel of procurement performance, estimatedwith data on the procurement arrangementsused by Ford Motor Company and ChryslerCorporation for all their major components. Ourresults show that performance differences acrossmodes of procurement arise as a function of thematch between adaptive capacity and adaptationrequirements associated with the exchange, andnot only the match between governance form andtransaction hazards.
THEORETICAL BACKGROUND
It is interesting to note that around thetime Ronald Coase was formulating his ideason transaction costs and their effects oncoordination in markets and firms (Coase,1937), Chester Barnard (1938) was emphasizingthe importance of adjustment processes inorganizations. As with Coase, Barnard’s analysisframed key contributions by later scholars(e.g., Simon, 1945; March and Simon, 1958;Thompson, 1967; Lawrence and Lorsch, 1967a,1967b), who saw the essence of organizationaladaptation as the generation of integratedresponses to changed circumstances. The followersof Barnard, however, emphasized the importanceof information rather than incentives (Grant,
Copyright
2005 John Wiley & Sons, Ltd.
Strat. Mgmt. J.
,
26
: 415–440 (2005)
 
 Adaptation in Vertical Relationships
417
1996; March and Simon, 1958; Simon, 1945;Thompson, 1967). Furthermore, while Coase’sdisciples focused on the boundary of the firmby assessing factors that impacted the make-or-buy problem, those who followed Barnard focusedprimarily on intra-organizational coordination.In the decades that followed, research in thetradition of Barnard rapidly accumulated onthe design attributes of complex organizationscomprising multiple, interdependent subunits thatenabled them to achieve coordinated adjustmentsto changes in their environment (Daft, 2001;Galbraith, 1977; Nadler and Tushman, 1998).We develop and extend this tradition of researchon organizational adaptation initiated by Barnardto the inter-organizational context. We analyze theadaptive capacity of vertical relationships in termsof differentiation and integration (Dougherty,2001; Ghoshal and Nohria, 1989; Lawrence andLorsch, 1967a, 1967b; Nohria and Ghoshal, 1994).Differentiation refers to the differences acrossorganizational subunits that arise as a consequenceof their local adaptation to unit-specific tasks andenvironments (Dougherty, 2001). Differentiationat the subunit level increases the responsivenessof the aggregate organization (and hence itsadaptiveness), as it creates organizational diversity.Differentiated and diverse organizational subunitscan recognize and engage in a wider search fornew opportunities when environmental conditionschange (Cohen and Levinthal, 1990; Ethiraj andLevinthal, 2004; Lawrence and Lorsch, 1967b;Rivkin and Siggelkow, 2003). Integration refersto the achievement of collaboration betweenorganizational subunits. It encompasses not onlycooperation (alignment of interest) but alsocoordination (alignment of actions) (Camererand Knez, 1996, 1997; Foss, 2001; Heathand Staudenmayer, 2000). Achieving integrationbetween interdependent organizational subunits isnecessary in order to respond effectively to change(Nadler and Tushman, 1998; Thompson, 1967; Vande Ven and Walker, 1984).By analyzing organizational attributes thatemphasize responsiveness and coordination (suchas differentiation and integration) in vertical rela-tionships, we propose to complement the richbody of research that has focused primarily onthe governance attributes of such relationships.We also extend prior research that has used thedifferentiation and integration constructs primarilyto study the adaptive capacity of the internalorganization of firms, by applying these con-structs to the context of vertical relationships.In developing our theory, we will argue thatdifferent modes of organizing vertical relation-ships—internal procurement, market procurement,and alliances—vary systematically in the extentof differentiation and integration between supply-ing and procuring units. As a result, they varyin terms of their adaptive capacity: their capac-ity to respond in a coordinated and cooperativemanner to changes in exchange conditions. Thesedifferences are reflected in performance differencesacross modes of procurement that face differinglevels of adaptation pressures in the transaction andtask environments. Those instances in which theadaptive capacity of the procurement arrangementmatches the adaptation pressures faced performbetter than those without such a match.
THE ADAPTIVE CAPACITY OFVERTICAL RELATIONSHIPS
In most prior research on the delineation of firmboundaries, scholars have studied two differentmodes of organizing vertical relationships: firmscan either ‘make’ (procure from an internal sup-plying unit within the firm) or ‘buy’ each compo-nent (from an external supplier outside the firm)necessary to complete their chosen product man-dates (Coase, 1937; Williamson, 1975). In recentyears, scholars have expanded this dichotomouschoice to focus on other ‘hybrid’ forms of orga-nization that are intermediate between make andbuy (Bradach and Eccles, 1989; Dyer and Singh,1998; Gulati, 1998; Helper
et al
., 2000; Poppo andZenger, 2002; Williamson, 1991a; Zaheer, 1995).In this study, in addition to make and buy, we focuson
vertical alliances
(or ‘ally’), a hybrid form thatindicates a relationship characterized by continuitybetween two independent firms operating at suc-cessive stages in a vertical chain of production,with both firms expecting the interaction to con-tinue into the future (Heide and John, 1990). Asopposed to arm’s-length exchanges, which tend tobe on the open market, discrete, and short term,vertical alliances tend to have a long time horizonor to be open ended (Ring and Van de Ven, 1992,1994). Since the exchange partners are ultimatelynot under the same legal ownership structure,however, the supplying and purchasing units retain
Copyright
2005 John Wiley & Sons, Ltd.
Strat. Mgmt. J.
,
26
: 415–440 (2005)

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