Supplier Switching Costs and Vertical Integration in the Automobile Industry Kirk Monteverde and David J. Teece Bell Journal of Economics BADM 546, Group #1 Meredith Blumthal Wooje Cho Barclay James Kumar Sarangee)

2 Purpose of the article: Draw on the literatures on transaction costs economics and industrial know-how. Use them to analyze efficiency initiatives for backward vertical integration in the United States automobile industry. Thus, explain why firms take parts production in house (a theory of the firm)

3 Hypothesis Assemblers will vertically integrate when the production process generates specialized, non-patentable know-how. WHY? (What is the causal reasoning?) In these kinds of production processes, both assemblers and suppliers are exposed to the possibility of opportunistic renegotiation of contracting High cost of switching to an alternative supplier due to difficulties of skill transfer. Possible loss of transaction specific know-how. Thus an assembler is locked into dependence upon a supplier to prevent these contractual hazard which then leads to vertical integration as the chosen option.

4 Automobile Industry - Characteristics Supplier switching costs associated principally with development activities for new automotive parts. Complex and long design process for a new vehicle model. Difficult to procure components by giving performance and design requirements to suppliers. Specs are often unknown ex-ante. Preproduction heuristic development is critically important to the evolution of many vehicle parts. This process generates production as well as design knowledge. First mover advantage to the supplier who works closely with assembler on preproduction development because of knowledge acquired during development (an example of Williamson’s, 1985: “fundamental transformation.”)

5 Hypothesis – Auto Industry The greater is the applications engineering effort associated with the development of any given automobile component, the higher are the expected “appropriable quasi rents” due to contractual problems and, therefore, the greater is the likelihood of vertical integration of production for that component.

6 Dependent Variable: Make or Buy? 133 sample automotive components taken to form the dependent variable. Used to ascertain the extent of vertical integration by GM and Ford for US production in Each component was recorded as either produced internally or sourced externally (dichotomous variable). Internal production of 80 percent or more of a component was taken as an operational definition of an integrated production.

7 Independent variables Applications engineering effort Operational measure – cost of developing a given automobile component. Data gathered from industry source – engineering cost rating for their sample of automotive components. This is a surrogate measure of relative engineering effort. Rating done on a 10-point scale with each component considered to require from none to a lot of engineering investment.

8 Control Variables To reduce the chance of a mis-specification of the model: 1 st – A “component specificity” variable, which distinguishes components specific to a company from those that are generic. 2 nd – Dummy variable relating to the identity of the sample firms. Controls for systematic differences between GM and Ford with regard to vertical integration. 3 rd – relates to system effects as different subsystems will display different levels of vertical integration.

9 Empirical Results Positive relation between the development effort associated with the design of any given automotive component to the likelihood of vertically integrated production of that component. Thus central hypothesis is corroborated empirically. Only components specific to a single assembler will be candidates for vertical integration. Mild support for systems effects.

10Conclusions Transaction costs considerations have important ramifications for vertical integration in the automobile industry. GM and Ford will bring component design and manufacturing in-house if reliance on suppliers for preproduction development service provides the suppliers with an exploitable first mover advantage (“fundamental transformation.”) This contractual hazard occurs because of potential high switching costs if the supplier acquires transaction specific know-how at the assembler’s expense. Difficulty in transferring know-how from supplier to suppler. Thus preference for backward vertical integration GM and Ford also prefer integration when components are firm- specific and their design must be highly coordinated with the other parts of the automobile system. these transaction conditions are those most likely to lead to contractual problems.