Technical Change, Competition and Vertical Integration Srinivasan Balakrishnan Birger Wernerfelt Strategic Management Journal (1986) by Eunkwang Seo Session 3: Transaction Costs Application

AGENDA  Research Questions Why certain investments in the long run would be more attractive to integrated firms than to independent suppliers? Two Explanatory Variables 1)Competitiveness of Market : An integrated firm will do better than an un-integrated firm if there are less participants and thus high profit in the value-added chain. 2)Technological instabilities : An integrated firm will do better than an un-integrated firm if technological changes occur less frequently in the industry.

1. THEORIES OF VERTICAL INTEGRATION  When is Vertical Integration Desirable? (1) 1)Competitive Considerations Vertical integration may provide competitive advantages to incumbents by increasing entry barrier (integration  concentration). Transaction cost theory maintains that rent earnings potential, indicated by a small number of participants, leads to integration (concentration  integration). 2)Production Economies of Integration Because of technological inseparabilities, the transfer of an intermediate product between successive stage of production may be costly. However, it is also possible for the separate owners to locate their plants adjacent to each other and carry out the transaction under market contracts (Mahoney, 1992).

1. THEORIES OF VERTICAL INTEGRATION  When is Vertical Integration Desirable? (2) 3)Transactional Economies Transactions under a hierarchy takes place because hierarchies have advantages to reduce transaction costs under market contracts. As the size and span increases, costs in administering transactions within the integrated firm also increases significantly. 4)Technological Instabilities Williamson (1975) argued that uncertainty in general leads to more vertical integration. For a particular type of uncertainty, such as the possibility of technological obsolescence, the relationship does, however, reverse. Because technological innovations wipe out prior investments, a highly volatile industry characterized by frequent technological changes will be unattractive for high levels of integration. Major Difference

2. ANALYTIC MODEL  A Simple Model (1) 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 Basically, ps reflects the ‘basic’ level of profitability in the industry reflecting the entry barriers associated with integration as as well as the specificity of assets. As vertical integration( v ) increases, market transaction costs ( m(1–v) ) decrease, but bureaucratic costs ( bv ) increase. ProfitsCosts

 A Simple 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 β 1 : The optimal level of vertical integration is lower in more competitive situations where the firm’s market share is low. The negative β 2 : Higher technological instability leads to lower levels of integration especially when market shares are low. 2. ANALYTIC MODEL NPV from investment v

 Methods Research Setting A sample of 93 SIC-4 digit level manufacturing industries. Given that p, b, m, r, and i are identical across industries, β 0, β 1, β 2 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 3. EMPIRICAL TEST

Empirical Test Estimation of cross-sectional model Estimation of pooled model (1974, 75, 76)

 Estimation Results As predicted, β 1 and β 2 are shown negative and statistically significant at the 0.05 level. The relatively low R 2, however, presumably suggests that other factors contribute significantly to the determination of integration strategy. 3. EMPIRICAL TEST

DISCUSSION  Technological Instability Leads to Less Integration? Tautology Issue The authors argue that for technological instable industries integration strategy is less preferred. However, since the authors define technological instabilities as the frequency of innovations wiping out prior integration investments, it seems to be tautological (something making a thing less preferred makes it less preferred). Flexibility of Integrated Firms Basically, integrated firms are regarded as less flexible than un-integrated firms. In my opinion, however, it ALSO depends on transaction costs in the market. If costs in searching appropriate partners, bargaining their transactions, and monitoring them are high, integrated firms that control their in-house behaviors by hierarchy can become more flexible to environmental changes.