86 / THE ECONOMIC INSTITUTIONS OF CAPITALISM
transaction costs. A brief discussion of strategic purposes, however, is also
included.
The commonsense explanation for vertical integration is that it has tech-
nological origins.2 That explanation is disputed in section 1. The main factor
to which I attribute a decision to integrate is a condition of asset specificity. A
simple model in which asset specificity is featured and in which the tradeoffs
between transaction costs and production costs are displayed is developed in
section 2. Further implications of this approach are developed in section 3.
Vertical Merger Guidelines are examined in section 4.
1. Technological Determinism
Ours is indisputably a technologically advanced society. That complex orga-
nization is needed to serve a complex technology is surely common sense. In
particular, comprehensive integration—backward into materials, laterally
into components, and forward into distribution—is widely believed to be the
organizational means by which complex products and services are created,
produced, and efficiently brought to market.
That conception is supported by the firm-as-production-function orienta-
tion. Large, integrated firms, wherein production is accomplished by joining
fungible inputs to yield outputs according to the engineering specifications,
are supposedly the rule rather than the exception. Reference to "physical or
technical aspects" sometimes buttresses this nonmarket presumption. The
standard example is the integration of iron and steel making, where the
The most popular [explanation] has been that when economies of scope between successive
stages due to technological organizational interrelationships are strong enough, these ac-
tivities should be provided under joint ownership (e.g., Chandler (1966]). Other arguments
for Vertical Integration have been the avoidance of factor distortions in monopolized
markets (e.g., Vernon and Graham [1971], Warren-Boulton (1974], Schmalensee 11973]);
uncertainty in the supply of the upstream good with the consequent need for information by
downstream firms (Arrow (1975)); and the transfer of risks from one section of the econo-
my to another (Crouhy [1976], Carlton [1979]). Furthermore, it has been pointed out that
transaction costs might create important incentives for vertical integration (e.g., Coase
119371, Williamson 11971, 1975)).
Omitted from this list is the incentive to use vertical integration as an organization shell to evade
taxes on intermediate products (Stigler, 1951) or as a device, through judicious use of transfer
pricing, to take advantage of differences among tax jurisdictions (that arise, for example, between
states). Jerry Green's recent examination of information externalities (1984) also warrants inclu-
sion. Yoram Barml (1982) and Douglass North (1978) trace vertical integration to difficulties of
measurement.
Tlic recent book by Roger Blair and David Kasennan (1983) provides an expansive survey
and assessment al the literature.
Vertical Integration: Theory and Policy / 87
realization of thermal economies is said to require integration (Bain, 1958, p.
381). Even, moreover, if tight technological linkages of that kind are missing,
existing configurations of assets are widely believed to reflect technological
principles. Especially among noneconomists, more integration is thought to
be preferable to less. Only in such rare circumstances where outside suppliers
have patents or where economies of scale or scope are very large would
outside procurement be seriously contemplated.
All of the above is plausible, which is to say that vertical integration
appears to be the unproblematic result of a natural technological order. I
submit, however, that intermediate product market transactions are much
more numerous than the conventional wisdom would suggest.3 The marvels
of the market to which Hayek referred in 1945 apply equally today. I further-
more contend that decisions to integrate are rarely due to technological deter-
minism but are more often explained by the fact that integration is the source
of transaction cost economies.
One way of putting it is as follows: Technology is fully determinative of
economic organization only if (1) there is a single technology that is de-
cisively superior to all others and (2) that technology implies a unique organi-
zation form. Rarely, I submit, is there only a single feasible technology, and
even more rarely is the choice among alternative organization forms deter-
mined by technology.
Recall in this connection the contracting schema in Chapter 1, where
general purpose and special purpose technologies are distinguished. Recall
further that the parties to the transactions so described have the option of
crafting governance structures responsive to their contracting needs. Only as
market-mediated contracts break down are the transactions in question re-
moved from markets and organized internally. The presumption that "in the
beginning there were markets" informs this perspective.
This market-favoring premise has two advantages. One is that it helps to
flag a condition of bureaucratic failure that has widespread economic impor-
tance but goes little remarked. (The issues here are briefly introduced in
ttection 3 and are more fully developed in Chapter 6.) Second, it encourages
the view, which I believe to be correct, that technological separability be-
tween successive production stages is a widespread condition—that sepa-
'Absent good measures of change in the amount of vertical integration, it is often inferred
1111111 the observed increases in firm size over time that the degree of vertical integration has
increased. But such increases in firm size are often a result of radial expansion, whereby the firm
grows to serve larger markets but the composition of activity is unchanged, or of diversification.
11 is evident that few consumer product firms are comprehensively integrated backward into raw
quiterials. And many manufacturers decline to integrate forward into distribution. Lateral Integra-
Ben Into components is also incomplete—•as an examination of the automobile industry (Omni
Motors, Ford, Chrysler, Toyota) discloses (Montcvcrdc and Tcecc, 1982).