An Empirical Examination of Transaction- and Firm-Level Influences on the Vertical Boundaries of the Firm Leiblein, Michael and Miller, Douglas. 2003. Strategic Management Journal Original by Ishva Minefee (9.11.2012) Modified by Jae Kyun Yoo (9.9.2014) Modified by Weiliang Zhang (9.2.2016)

Study’s Motivation Foundational question: Why do firms vertically integrate? Transaction cost economics (TCE) accounts for significant amount of previous research, and suggests ‘that the optimal form of organization is primarily a function of the characteristics underlying a given exchange’ (p. 839) This research article however, maintains that TCE is limited in its explanation of vertical integration. The literature typically does not account for firm-specific attributes as drivers of vertical integration.

Literature Background Transaction Cost Economics Vertical boundary decisions are likely to be influenced by ‘characteristics associated with the efficiency of the chosen form of organization’ (Klein et al., 1978; Williamson, 1975) Neglects capabilities Resource-based view (RBV) Firm-specific governance decisions may arise from prior commitments, exchange relationships, and capability differentials Real options theory Explains tradeoff between efficiency of competing forms of organization and the value to operate flexibly in an uncertain future

Hypotheses and Conceptual Model

Data Sample Sample Production activities of 117 global integrated circuit manufacturers (ICE, 1997) Non-random Unit of analysis: production decision (total of 469) 358 – internal production 111 – external production-sourcing relationships

Variables Dependent Variable Independent Variables Control Variables Production decision (Make versus Buy) Independent Variables Asset specificity Demand uncertainty Fabrication experience Sourcing experiencing Diversification strategy Control Variables Ex ante small numbers Firm size Firm tenure Geographic region Year

Statistical Methodology Endogeneity/Econometric Identification Concerns Potential for self-selection bias: Heckman (1978) correction Inverse Mills ratio used in two-stage Probit analysis Potential simultaneity problem between dependent and independent variables: Instrumental variables via a Hausman test

Findings The interaction of high asset specificity (measured by exchange involving analog, memory, or customized ASIC products), and high demand uncertainty (measured by the variance surrounding a time trend in the demand for similar products) increase the likelihood of vertical integration (TCE hypothesis 2b is corroborated). A firm’s past experiences (embodied in past production expertise using the relevant process technology) increase the likelihood of vertical integration (RBV hypothesis 3 is corroborated). A firm’s past experiences (measured by the number of prior outsourcing relationships over the past 5 years) reduce the likelihood of vertical integration (RBV hypothesis 4 is corroborated). Firms with higher levels of diversification across product-markets increase the likelihood of vertical integration (Real options hypothesis 5 is corroborated).

Conclusions Firm-level capabilities and strategies independently and significantly influence firms’ vertical boundary choices. Firms with more process technology experience are more likely to internalize manufacturing activities. Firms with high levels of sourcing experience are more likely to outsource their production. Product-market diversification (a measurement of firm strategy) is associated with greater likelihood of internalizing production. There is benefit both to economizing and strategizing.

Discussion Even though transaction cost theory suggests that asset specificity would increase vertical integration, Hypothesis 1 was not supported. What could be possible reasons for this outcome? Even though transaction cost theory suggests that demand uncertainty would increase vertical integration, Hypothesis 2 indicates a weakly significant negative effect. What could be possible reasons for this outcome? Is there are a possibility of reverse causality or restriction in the choice of make-or-buy decisions considering path dependency? Example: Vertically integrated firms increase fabrication experience while de-integrated firms increase sourcing experience. / Diversification could occur due to excess capacity in current business.