Technical Change, Competition and Vertical Integration Srinivasan Balakrishnan and Birger Wernerfelt Strategic Management Journal BADM 546, Group #1 Meredith Blumthal Wooje Cho Barclay James Kumar Sarangee BADM 546

Overview Research Question: Vertical Integration Why would certain investments in the long run be more attractive to integrated firms than to independent suppliers? Vertical Integration The combination of technologically distinct production, distribution, selling and/or other economic processes within the confines of a single firm… a decision by the firm to utilize internal or administrative transactions rather than market transaction to accomplish its economic purpose. (Porter) BADM 546, Spring 2005

Theories of Vertical Integration Economies of Integration The strategy of integration will be preferred: Competitive Considerations: when integration introduce entry or mobility barriers to competition resulting in higher revenues to the integrated firm Production economies: when there are production economies of scope Transactional economies: when there are transactional economies in integration Investments in specialized assets and technological change: if the technology is expected to be relatively short-lived, the decision not to integrate is correct BADM 546, Spring 2005

A Simple Model A firm’s integration strategy depends on: Competitive considerations Market transaction costs Bureaucratic diseconomies Technological instabilities Model for firm’s profitability and integration π (v) = vps [1 - m (1 - v) - bv] v: faction of being selected parts of the value-added chain in the industry s: market share (p*s: basic level of profitability in the industry m: fraction of the profits lost in market transactions b: fraction lost in bureaucratic transactions BADM 546, Spring 2005

A Simple Model Expected Net Present Value of all future profits Optimal level of integration v* T: expected time to the innovation r: discount rate i: the rate of investment elsewhere except the internal value-added chain m: fraction of the profits lost in market transactions b: fraction lost in bureaucratic transactions BADM 546, Spring 2005

A Simple Model Three separate cases: When v* = 0 When v* = 1 The firm would prefer a negative level of participation Very common case No firm participates in all industries and can thus be said to have decided against participation in some industries When v* = 1 The firm would prefer to invest more than the maximum feasible amount in the industry Very rare case Ex. Some petrochemical firms When 0<v*<1 Need to find optimal value of v* (optimal level of vertical integration) The empirical study of this paper focus on the case BADM 546, Spring 2005

Empirical Test Purpose: Analyze the effect of technological instability (1/T) and the market share of a representative firm (s) Analysis level: industrial level Assumptions p, b, m, r, and i are similar across industries The linear relation between equilibrium market share and profitability may be reasonably valid across different industries Testing Model vi = β0 + β1 (1/s) + β2 (1/s) (1/T) + ei BADM 546, Spring 2005

Empirical Test Measuring Data Level of vertical integration (v): a vertical integration index which measures the proportion of economic process carried out within the firm Market share for a representative firm (s): MES (Minimum economic scale) Mean life of the process technology (T): average age of plant and equipment in use Data 93 SIC-4 digit level manufacturing industries which are randomly selected from among the 261 industries included in the FTC Annual Line of Business Reports BADM 546, Spring 2005

Empirical Test Results The results are consistent with the theoretical expectation Level of vertical integration decreases as competition goes up By lowering the entry barriers Integration levels are lower in industries characterized by frequent technological changes BADM 546, Spring 2005

Conclusions Especially if the degree of competition is high, integration is affected negatively by the frequency of technological change The optimal level of integration depends negatively on the degree of competition in the industry However, vertical integration strategy is a complex and controversial topic, so simple-minded rules of thumb are potentially misleading BADM 546, Spring 2005