Why do or don’t firms own their own vertical production

chains?

Student Numbers: 493439, 495931, 497564, 508373

Date: 28th March, 2021 Word Count: 3733

Introduction
Make-or-buy decisions involve a variety of choices concerning whether firms should vertically integrate or
purchase inputs from outsiders instead. It is one of the first diversification strategies companies consider
when making decisions about expansion. Thus, it has been an important subject of theoretical and empirical
research for several decades. This subtopic of research was inspired by Coase (1937) in his seminal paper
‘Nature of the Firm’, which states the economic reasoning behind why vertical mergers and partnerships
occur. The literature since then has built on Coase’ work and focused on primarily two themes. Firstly, many
studies explore reasons for vertical ownership in a multitude of circumstances. Secondly, there is research
on the consequences of vertical integration, along with potential alternatives that could be used such as
market transactions (outsourcing), partnership networks or tapered integration. The following literature
review outlines the findings within these themes, explains linkages and developments of older theories and
conclusively, discusses the social and scientific relevance of a new research question that is yet to be
properly researched in this subfield.

Reasons for Vertical Integration

This section will explore the general and specific motives for owning vertical production chains across a
variety of industries. Within the literature, vertical integration has been studied mainly in the incomplete
contracts setting, where contracts about a transaction between the buyer and seller cannot specify all
solutions for each possible contingency. Crocker (1983) uses this setting to illustrate that firms could
strategically use information about their production costs, etc. to bargain the incomplete aspects of the
contract. Crocker says private information provides incentive to use this information for higher production
efficiency and profit maximisation. As a result, unintegrated firms may engage in opportunistic behaviour to
strategically appropriate higher quasi rents. Vertical integration eliminates this motivation and instead,
realignes the firms’ incentives toward cost-efficiency in production. With regards to exploiting opportunistic
behavior, incentives to vertically integrate exist regardless of whether the upstream process is regulated or
not (Beard et al, 2003). It may also be an attempt to “sabotage” competing firms by raising their costs via
non-price activities. Stuckey and White (1993) use a similar contracts setting and detail that vertical
integration is desirable to a firm when market failure occurs. It occurs because of costly contracts, few
market participants, high switching costs due to asset specificity, and transaction frequency. Earlier findings
of Levy (1985) provide empirical support for this situation. They find that unanticipated events (those not
accounted for in contracts) share a positive relationship with vertical integration. They also find a negative
and significant association with firm size, possibly due to higher switching costs and asset specificity of
larger firms. He concludes that firms mainly integrate when the market transaction costs are higher than
internal management costs.

Building on the work of Levy (1985) on the topic of unanticipated events, Williamson (1989) also argues that
uncertainty is a reason for vertical integration. However, other research reveals mixed findings of this claim.
Coles and Hesterly (1997) investigate make-or-buy decisions in public and private hospitals and confirm the
effect of uncertainty on vertical integration. Sutcliffe and Zaheer (1998) hypothesize and distinguish
between primary and competitive uncertainty as drivers for vertical integration. Primary uncertainty is
described as having scarce information about natural events, whereas competitive uncertainty suggests a
lack of information on the behaviour of other economic agents. Yet, both forms of uncertainty are found to
be negatively related with vertical integration. A third distinction is made for supplier uncertainty (regarding
uncertain trading partner behaviour), which is found to be positively associated with vertical integration.
Acemoglu et al. (2010) built on Williamson's (1989) theory of vertical integration using an incomplete
contracts model to find determinants of vertical integration. They found that technology (R&D) intensity of
downstream (producer) industries has a positive correlation with the likelihood of integration, whereas the
R&D intensity of upstream (supplier) industries has a negative correlation. They also found that competition
- proxied by the number of firms - in upstream and downstream industries is a key determinant to vertical
integration. More firms in upstream (supplier) industries reduces the probability of vertical integration,
while more firms in downstream (producer) industries increases this probability.

Harrigan (1986) distinguishes between four types of integration, namely: vertical, horizontal, forward and
backward integration. Forward vertical integration is when a firm expands its operations by
owning/controlling a stage ahead in the value chain. One method of exploiting forward vertical integration
is via franchising. Lafontaine and Shaw (2005) use panel data to show that firms with greater brand name
value own more of their outlets, maintaining a steady level of corporate ownership. However, the rate of
company ownership is found to vary significantly across firms. They argue that higher brand name firms
have high rates of company ownership to ensure protection against franchisee free-riding. Guan and Rehme
(2012) further explore factors driving downstream/forward vertical integration and find that the size of
retail chains and the manufacturer’s positioning strategies were the two most important factors driving
forward vertical integration.

Acemoglu et al. (2009) study the effect of institutional features on vertical integration decisions by firms.
Their model concludes that contracting costs and financial development, by themselves, do not have a
significant effect on vertical integration; the correlations found were entirely explained by differences in
industrial composition between countries. However, the model suggests an important interaction effect of
contracting costs and financial development together. Greater vertical integration is found in countries that
have high contracting costs and greater financial development - proxied by credit market development
scores. They show that capital-intensive industries, where contracting costs are high, have higher vertical
integration. Lastly, Atalay et al. (2014) explore reasons why many firms own links of production chains. They
find that most vertical ownership is not mainly for facilitating movement of goods along the production line.
Across the 67,500 establishments used in their dataset, the median fraction of shipments to upstream
establishments is 0.4%. They propose that instead, vertical ownership is mainly used to promote
movements of 'intangible' inputs within the chain, for example: management oversight over production
units, etc.

Looking at the existing literature on VI, there is a clear divide between papers with Neoclassical
underpinnings, and those from a managerial background. Lafontaine and Slade (2007) take empirics from
Neoclassics and human capital considerations from managerial literature to model the relationships
between VI and factors such as moral hazard, transaction costs, property rights, and market power. While
the authors could not make conclusions about the actual effects, they did highlight the importance of taking
into account all confounders when exploring the effects of VI.

Leuschner et al. (2013) stress that the potential benefits or downsides of VI might only materialise over
time, and not immediately. While VI and firm performance (FP) often share a significant and positive
relationship, this relationship is nonlinear and may take time to develop. They claim that sometimes, this
VI-FP relationship may prove not to be positive, as operational integration can have mixed results. This
non-linear relationship may be explained by the empirical study by Li and Tang (2010), which explores the
effect of VI on innovation performance (IP). They find a U-shaped relationship, with IP increasing shortly
following VI, and subsequently decreasing. The paper also shows that vertically integrated firms are more
likely to enhance their innovation, as firms with low VI will rely more upon external knowledge sourcing.
This is also the result of Perols et al. (2012), who show that vertically integrated firms tend to adapt to more
external technologies. They also explore the relationship between VI and time-to-market (time period
starting from the origin of the idea until it is released). In scenarios where the supplier and firm work
together closely, faster time-to-markets are observed.
This complex supplier-firm relationship is also present in the automotive industry (Monteverde & Teece,
1982). They find that firms are more likely to vertically integrate if reliance on suppliers gives them an
exploitable first-movers advantage. The same paper, however, also points out large international disparities
in when firms should and should not integrate. Japanese automotive manufacturers for example, tend not
to vertically integrate as they share very close ties to their suppliers, relative to their US counterparts.
Sumner and Wolf (2002) also explore geographic differences, this time in the dairy farm industry. They find
that US dairy farm herd size is strongly negatively related to the level of VI, and that there are strong
regional differences in the degree of VI. Farms in more urban states tend to have higher VI. For industries
with many value-added products VI, they find, can generate profits far higher than without VI.

Another paper by Klein (1988) also explores the automotive sector. Klein posits that the primary reason for
VI is the elimination of contractually induced holdups. He argues that rigidity from firm specific assets not
owned by the firm causes a heavy reliance upon suppliers, which drastically decreases the firm's bargaining
power. The effect of VI on bargaining power is also explored by Harrigan (1985), who concluded that the
higher the supplier bargaining power of the firm, the less need there is for VI. Harrigan explored the
relationship between many factors and VI. Sales growth was the factor that shared the strongest positive
relationship with VI. According to Harrigan, VI also has a strong effect on the availability of outside
customers. The study also showed that in sectors with high exit barriers, forward integration was less likely.
A study on the video game industry made remarks not on barriers to exit, but on barriers to entry, finding
that VI and exclusive contracting greatly aided platform entry (Lee, 2013).

Bargaining power ties in strongly with the overall market power of a firm. Hortacsu and Syverson (2008)
study the cement industry, finding that VI has a negligible effect on market power. They found that it was
not high-productivity producers who were more likely to be more vertically integrated, but that lower prices
were the result of improved logistics coordination in large firms. For the financial sector, we observe an
interesting relationship between VI and financial performance. Lahiri and Narayanan (2013) found that
strategic alliance benefits are lower for highly vertically integrated firms than for “normal” firms. This once
again emphasizes the non-linear relationship seen between VI and FP. Overall however, we do see that VI
results in higher financial performance.

Armour and Teece (1980) study the relationship between VI and technological innovation in the US
petroleum industry. They hypothesize that additional stages of VI will enhance innovation performance, via
the sharing of technology between different stages of the supply chain. This would facilitate smooth
implementation of technology when interdependencies within the firm are involved. The paper finds a
significant positive effect of VI on innovation, with each additional “stage” incorporated bringing upwards of
$1 million in total R&D spending. The authors, however, emphasise that R&D spending lags behind firm
growth through VI, which may explain the U-shaped relationship characterised by Li and Tang (2010).

Alternatives to Vertical Integration

This section discusses some alternatives suggested by economists with regards to diversification strategy.
Mahoney (1992) suggests three main disadvantages of vertical integration, namely: bureaucracy costs,
considerable investment in new operations, and high production costs. He concludes that vertical
integration relative to market transactions depletes a firm’s financial resources, which could be detrimental
especially to small firms.

Larson (1991) proposes partnership networks as a competitive substitute to vertical integration. This
alternative is particularly relevant for small firms that lack the funds necessary to vertically integrate and
compete with larger rivals. It also provides the added benefits of vertically integrated processes while
avoiding the associated bureaucratic inefficiencies, and staying adaptable within a dynamically changing
market. He observes that partnering firms build informal alliances involving open communication, joint
planning, process streamlining to form mutually beneficial ties without the delays and capital investments
tied to vertical integration.

Mahoney (1992) synthesizes other empirical findings on the disadvantages of vertical integration and
suggests that in the absence of agency and transaction costs, vertical ownership and
contracting/outsourcing are equivalent governance structures for achieving corporate objectives. Argyres
(1996) also discusses outsourcing, through the example of an single firm, and states that firms opt for
outsourcing over vertical integration when suppliers abroad possess superior capabilities. These capabilities
matter most when production information is proprietary or tacit, and absent from local markets. Another
reason why outsourcing is suggested as a suitable alternative is due to its positive association with firm
efficiency. Görzig and Stephan (2002) estimate the impact of three types of outsourcing on the factors that
determine firm performance, namely: increasing material outputs, subcontracting production and external
services for e.g. consulting, etc. They find that in the long run, the first two types of outsourcing have a
positive impact on return per employee, a measure of firm efficiency. Firms that increased external services
relative to internal labor costs performed worse in this regard.

Acemoglu et al. (2003) hypothesize that the distance of a country to the worlds' technology frontier (the
next phase in the evolution of technology) is a determinant of a firm’s vertical integration decisions. In
vertically integrated firms, owners must focus on production as well as innovation processes, which leads to
managerial overload. Outsourcing production functions ease this managerial overload. For economies
further away from the technology frontier, owners favour vertical integration because innovation is less
dominant than imitation in these economies; the benefits of superior capabilities of outsourcing are then
lower than its costs.

Since most prior research focused on vertical integration or outsourcing in isolation, Hitt et al. (2006)
explores tapered integration: using vertical integration and outsourcing simultaneously. Tapered integration
was found to have a positive effect on the development of a firm's product portfolio, and the success of
those new products upon introduction to the market. An increase in both these factors contributed to the
firm's competitive advantage and overall firm performance. The authors further suggest using tapered
integration over vertical integration in isolation, because they find a negative correlation between vertical
integration and new product success.

Conclusion
Over 30 academic papers have been considered in this literature survey to explore the research area. Many
of those papers sought to either delve deeper into the VI-firm performance relationship, within a specific
industry, such as Forbes and Lederman (2009) in the airline industry. Others aimed to identify the
relationship between VI and specific factors such as innovation, like Armour and Teece (1980). Much of the
literature around VI builds on the classic works by Coase (1937), Williamson (1989) and Levy (1985), and is
primarily concentrated on the transaction costs economics (TCE) framework. This framework advocates for
minimising costs of exchange, however does not consider nation-level factors, like culture, as variables that
influence the degree of vertical integration.

These national differences in levels of VI are somewhat explored by Monteverde and Teece (1982), in their
discussion of VI in the automotive industry. They find that compared to US automotive manufacturers, the
Japanese counterparts engage in far lower levels of VI, and posit that this is due to the massive cultural
differences between the two nations. The specific differences that do play a role, however, is not explored.
Thus, the question arises:

To what extent do culture and other national-level differences affect a firm's optimal level of
vertical integration?

This research question has scientific and social relevance. No discernible research was found on the national
level differences in VI across countries, nor the factors causing these disparities. While some papers have
mentioned that national differences exist, no credible papers were found that empirically investigate the
causes of these. Ultimately, the goal of economic and econometric research is to better understand causal
relationships between variables of interest. For VI, cultural norms and national level differences like firm
hierarchy, quality of institutions, etc. are two such possible causal factors that are not fully understood.
Research within this subtopic benefits multinational corporations who have subsidiaries in other countries,
and are exploring options for upstream or downstream FDI. Furthermore, for firms to establish a
competitive advantage, they must be able to understand exactly what decisions to make, when, and where.
To make an effective cost-benefit analysis on VI, firms (especially multinationals) must be able to
understand and model regional, national, and cultural factors that influence that decision.

While it is impossible to fully understand all elements affecting the decision to VI, great strides can be made
by conducting more macroeconomic research, like that which we propose in our research question. Then,
truly, the question: “why do or don’t firms own their own vertical production chains?” can be better
answered.
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