1. Technical Change, Competition and Vertical Integration
Srinivasan Balakrishnan and Birger Wernerfelt
Strategic Management Journal, 1986
BADM545, Fall 3012; Prepared by: Hyunsun Kim

2. Introduction Strategic perspectives Research question:
Purpose: long-term profit maximization
Premises
Future-oriented
Commitment of resources, costly to revoke
Emphasis: implications of changes in technological conditions
Research question:
Why certain investments in the long run would be more attractive to integrated firms than to independent suppliers?

3. Introduction Previous literatures Predictions regarding uncertainty
Transaction cost economics: higher profits in the value-added chain -> greater performance for vertically integrated firms
Standard economics: specialized assets (skills) -> greater profits
Predictions regarding uncertainty
Uncertainty, in general, will lead to more vertical integration (Williamson, 1975)
Greater numbers of contingencies: greater costs for contracting
However, a particular uncertainty, the possibility of technological obsolescence, reverses the relationship
Single contingency, decreasing value of the investment

4. A Simple Model the optimal level of integration in an industry
increases with: transactional economies
decreases with: bureaucratic diseconomies, competition and technological instabilities
Optimal level of integration: v*
The firm’s greater market share (s) -> high v*
Higher technological instability (1/T) -> low v*
Industry profitability (r,p) -> high v*
Rewarding alternative investment (i)-> low v*
Bureaucratic costs(b) -> low v*

5. Empirical Test Unit of analysis: industry Measures Data
Greater variances for market share (s) and technological instability (1/T)
Measures
Vertical integration
Vertical integration index (VI): the proportion of economic activities carried out within the firm (=value added/sales ratio)
Market share for a representative firm (s)
Minimum economic scale (MES): the average size of the largest firms in the industry which account for 50 percent of the total value of the industry shipment
The mean life of the process technology (T)
Average age (AVAGE) of plant and equipment in use
Data
93 industries, FTC Annual Line of Business Reports,

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

7. Conclusion Results Implications
The frequency of technical change negatively affects vertical integration, when competition is high
The optimal level of integration depends negatively on the degree of competition in the industry
Implications
Transaction cost economics for strategic analysis/strategic flexibility