Advanced Corporate Strategy

ST104x

Motives for vertical integration

We will next discuss the motives for vertical integration:

• These include mitigate holdup risk,
• achieve superior coordination,
• increase barriers to entry,
• protect intellectual property,
• third degree price discrimination,
• reduce cyclicality or volatility in earnings.

We will also look at some spurious motives, motives that do not stand when scrutinized
carefully.

The starting point for discussing the motives for vertical integration is to note that the make
or buy decision question is equivalent to the question of when does a firm have an advantage
over the market and vice versa. This even raises the fundamental question of why firms exist.
Several scholars have tried to answer this question and the most prominent answer comes
from the field of transaction cost economics.

According to transaction cost economics or TCE, the make or buy decision depends upon
whether transaction costs - the costs of organizing a transaction in the market are higher or
lower than the administrative costs of organizing the same within a firm.

What is a transaction?

A transaction occurs whenever something is being exchanged or traded. For example, when
a firm buys a component from another firm a transaction occurs. These transactions have
costs associated with them.

They include

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 Advanced Corporate Strategy

ST104x

• the costs of searching for an appropriate supplier,

• the costs of negotiating a contract and
• the costs of monitoring and enforcing the contracts.

The buy vs make decision is based on their relative magnitude of transaction caused and
administrative cost. If the transaction costs in the market are higher than administrative costs
within the firm, then a firm should make and if transaction costs in the market are lower than
administrative costs within the firm, then a firm should buy.

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