Technical Change, Competition and Vertical Integration Srinivasan Balakrishnan & Birger Wernerfelt Strategic Management Journal (1986), 7(4): 347-359 Presented by Julie Ao, Fall 2017

Summary More competitors → Less specialized assets and lower profits The paper analyzes the vertical integration strategy from a long-term profit-maximization perspective. RQ: Why certain investments in the long run would be more attractive to integrated firms than to independent suppliers? Vertical integration is less desirable in industries with more participants and more frequent technical change. More competitors → Less specialized assets and lower profits More technical change → Low value of specialized assets in their secondary use

Theories of Vertical Integration In order to choose integration Economies of Integration Competitive considerations: Integration introduces entry barriers to competition Higher revenues for integrated firms Production considerations: Technological inseparabilities Production economies of scope Transactional economies: Hierarchy reduces transaction costs Technological instabilities: Short life → less valuable → fewer profits → fewer incentives to integrate Higher revenue for integration Lower production costs for integration Lower transaction costs for integration

Analytic Model Aim to show the optimal level of integration in an industry increases with transactional economies, and decreases with bureaucratic diseconomies, competition and technological instabilities. π : the profit of the down-stream firm v: the fraction of resources invested in the value-added chain in its industry s: the firm’s market share in the consumer market m: the fraction of profit lost in market transactions b: the fraction of profit lost in bureaucratic transactions

Analytic Model (2) T: the expected time to innovation that will wipe out the investment v i: the rate of return on the remaining part of the firm’s capital (1-v) r: the discount rate (r > i) The negative β1 : The optimal level of vertical integration is lower in more competitive situations where the firm’s market share is low. The negative β2 : Higher technological instability leads to lower levels of integration especially when market shares are low.

Empirical Test Research Setting: Measures: Cross-sectional Model: Sample of 93 SIC-4 digit level manufacturing industries p, b, m, r, and i are identical across industries, β0, β1, β2 can be estimated with cross-sectional data Measures: Vertical integration: the proportion of economic processes carried out within the firm (vertical integration index) Competitiveness : the average size of the largest firms in the industry which account for 50 percent of the total value of industry shipments. Technological instabilities: the average age of plant and equipment Cross-sectional Model:

Results Two main results: NOFRM (1/s) measures the number of significant competitors; INNFRM (1/T) measures the technological instability Two main results: 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

Discussion This paper’s argument contradicts with Williamson’s argument? Williamson (1975): uncertainty leads to more vertical integration “As the number of contingencies in the contract goes up, it becomes more expensive to write, monitor and enforce.” Williamson (1979): environmental unpredictability is one form of environmental uncertainty (Anderson and Schmittlein, 1984) Technological obsolescence < Technological uncertainty < Environmental unpredictability < Environmental uncertainty < Uncertainty [?] Mahoney (1992): Harrigan’s (1985) view does not contradict with Williamson’s Williamson (1979): the effect of uncertainty when the level of asset specificity remains constant Harrigan (1985): the effect of uncertainty in a dynamic contingency framework