CHANDLER’S LIVING HISTORY Bucheli, Mahoney and Vaaler (2010) Presented by Yifan for BADM549 (FALL 2012)

Theme Applies transaction cost theory to several case studies from Chandler’s masterwork, The Visible Hand, narrating the emergence of vertically-integrated firms in 19 th century U.S. Transaction cost: the costs of producing and overseeing the exchange of goods and services over time Transaction cost theory: define the circumstances when internalization is more cost-efficient than leaving transactions in the market

‘putting-out’ and inside-contracting system Before the 1840s, ‘putting-out’ and inside-contracting systems dominated ‘putting-out’: market-based and decentralized Merchants purchased materials, delivered them to the workers in their homes, and arranged for the sale for the completed articles Fits the world of lacking low-cost capital, technology, transportation, and communication Separate work locations, piece-rate compensation system, loss in transit, time-lags in production, uneven product quality

‘putting-out’ and inside-contracting system ‘inside-contracting’: market-based incentive dominated, but not completely company supplied raw materials, the use of floor space and machinery, light, heat and power, special tools, and patterns for the job. Inside contractor hired and fired their own workers, set wages, managed jobs, and turned over the finished parts to the company for assembly. Disadvantages: misuse of machinery, quality shading, problems of workers’ discipline, no job security

Rise of vertical integration From 1840 to 1920, a trend in internalizing market transactions by ‘backward’ acquisition of basic inputs and ‘forward’ acquisition of final output channel technological innovation (railroads, telegraph, water and steam power, production) increasing sophistication of demand

Rise of vertical integration firms producing technologically complex goods: Singer Sewing Machine, McCormick Harvesting Co. integrated mass production with mass distribution warranty and installment financing plans franchised agency system that distributed products and plans salesroom specialized investments in training and knowledge-development branch retail outlet network (National Cash Register Co, Eastman Kodak, Remington Typewriter) coordination between production and marketing departments

Rise of vertical integration Firms producing perishable goods Meat packer Swift’s: built own refrigeration cars and established own ice station and branch houses Banana company United Fruit Co. merger of railway and banana plantation companies allowed both backward and forward vertical integration creation of Fruit Dispatch for distribution, becoming shareholder of Hamburg Line and Elders & Fyffes for transportation, creation of Tropical Radio & Telegraph for communication

Selective nature of vertical integration Challenging circumstances required: faster distribution, deep knowledge of product specifications and repair techniques, deep knowledge of consumer credit risk and financing → need to make specialized investment in training and equipment Small-numbers bargaining issues asset specificity were low, market-based transaction was less costly and vertical integration proved financially unsuccessful (e.g., breakfast cereals, drugs, liquors, jewellery, textile, brewery, etc.)

Chandler and Today Chandler’s historical analysis of transition in worker practice lends itself to transaction cost model by Williamson: from contracting worker to employment relationship in team (less bargaining, specialized investment in training) Transaction cost model helps to understand contemporary vertical de-integration: the rise of information technology alleviates the asset specificity and small-numbers bargaining problems