Vertical Integration Decisions Research Articles

PRODUCT DIFFERENTIATION STRATEGY AND VERTICAL INTEGRATION: AN APPLICATION TO THE DOC RIOJA WINE INDUSTRY

This study evaluates the importance of product differentiation as a determinant of vertical integration in firms. The proposed model also controls for known determinants of integration, such as transaction costs and firm-level capabilities. By identifying transaction-, firm- and strategy-level determinants, we derive testable predictions about the vertical integration decision. To test these predictions we analyze the Rioja wine industry, using a representative sample of 187 firms. Our paper concludes that reaching judicious vertical integration decisions requires a thorough analysis of some very diverse aspects, especially those related to mitigating opportunism, dealing with unforeseen contingencies and product differentiation.

Outsourcing versus vertical integration: Ethier–Markusen meets the property‐rights approach

AbstractEarly analyses of direct investment versus outsourcing focused on the existence of knowledge‐based assets, knowledge being non‐rivaled and non‐excludable. Ethier was the first to formally model the consequences of non‐excludability for the vertical integration versus outsourcing decision. Later authors took a different approach, modeling physical capital as fully excludable but relationship‐specific. This paper further develops a model with both non‐excludable knowledge capital and fully excludable physical capital. Results show that vertical integration tends to be chosen when (a) the technology is relatively knowledge intensive and/or when (b) knowledge and physical capital are strong complements.

How Vertical Integration Affects Firm Innovation: Quasi-Experimental Evidence

While theory proposes that firm boundary decisions have profound performance implications, there is little direct evidence on the consequence of vertical integration decisions for firm innovation. In this paper, I draw from transaction cost economics and the knowledge-based view to argue that vertical integration increases firm innovation and that this effect is contingent on characteristics of the knowledge involved in the integration. Using a quasi- experimental research design and a sample of vertical mergers, I find a causal impact of vertical integration on firms’ subsequent innovation outcomes; moreover, the causal impact is stronger when integration involves complex or original knowledge. Thus, while firm boundary decisions have a direct impact on firm innovation on average, such impact is also contingent on particular knowledge characteristics such as complexity and originality.

Transactional hazards, institutional change, and capabilities: Integrating the theories of the firm

Using a detailed dataset from the Chilean construction industry, we explore how the predictions of the transaction cost and capabilities theories interact to explain building contractors' decisions to ‘make or buy’ the specialty trade activities needed to complete a construction project. We show that the contractor's productive capabilities strongly mediate the relationship between transaction hazards that originate from either temporal specificity or an exogenous change in the subcontracting law and the vertical integration decision. The inclusion of differential capabilities and its interaction with transactional hazards infuse contractors' boundary choices with systematic patterns of heterogeneity and contribute to the integration of these theoretical perspectives. Our analysis corrects for the endogeneity of the capabilities variable and provides a detailed assessment of the marginal effects in logit models. Copyright © 2013 John Wiley & Sons, Ltd.

Managerial Risk Aversion and Vertical Integration

In this paper, we provide a new explanation for vertical integration decisions and the wealth effects of those decisions. Our hypothesis is based on managerial risk aversion. Agency theory posits that differences in risk preferences between managers and shareholders can impose costs on shareholders. Using CEO relative inside leverage (the ratio of the CEO’s inside leverage to firm leverage) to proxy for managerial risk aversion, we find that CEOs with higher relative inside leverage are more likely to engage in vertical mergers. Furthermore, vertical acquisitions made by CEOs with higher relative inside leverage generate lower announcement returns, and this negative effect of CEO relative inside leverage on acquisition returns for shareholders is more pronounced when the acquirer has a higher degree of informational opacity, weak corporate governance, excess cash holdings, and higher cash-flow volatility. Further analyses show that CEOs with large inside debt holdings tend to overpay in vertical acquisitions, which might be one channel through which such acquisitions damage shareholder wealth. Our study provides new evidence on how managerial objectives affect shareholder wealth in merger and acquisitions.

Equilibrium Vertical Integration with Complementary Input Markets

Abstract We provide a model to investigate vertical integration decisions. This model assumes that local downstream manufacturers require two inputs to make their final products. One input is produced by a supplier shared by both manufacturers; another is produced by an exclusive supplier for each manufacturer. We show that vertical integration of each downstream firm with its exclusive supplier enhances the input demand for the common supplier, leading to an increase in the common supplier's input price due to the elimination of the double marginalization. Moreover, downstream firms that require a smaller quantity of inputs from the common supplier, for instance, those with efficient production technology or smaller downstream demand, are more likely to vertically integrate because vertical integration yields a smaller increase in input price. Thus, the cause of firm-size heterogeneity is important to consider when investigating the relationship between firm size and the tendency to vertically integrate.

The Influence of Low-Cost Carriers on the Use of Regional Airlines

This paper investigates the competitive effects of legacy carriers' vertical integration decision with independent regional airlines. Legacy carriers are more inclined to operate a route using a regional airline partner, as opposed to its own fleet, when a low-cost carrier enters that route. Moreover, legacy carriers' airfares are lower on routes operated by an independent regional airline. The results suggest that legacy carriers exploit the more cost-efficient regional airlines in order to lower prices and better compete with low-cost carriers.

Vertical integration to avoid contracting with potential competitors: Evidence from bankers' banks

We examine a vertical integration decision within the commercial banking industry. During the last quarter of the 20th century, some community banks reduced their traditional reliance on correspondent banks for upstream products and services by joining bankers' banks, a form of business cooperative. Research on vertical integration focuses primarily on firm-specific investment, market power, and government regulation. However, this case is difficult to explain in terms of these standard vertical integration motives. Our evidence suggests that bankers' banks are a response to technological change and deregulation that results in increased costs faced by community banks in dealing with correspondent banks as both suppliers and potential competitors. For instance, loan participations require sharing proprietary information about major loan customers, something a community bank would not want to provide to a potential competitor.

Determinants of the Differences in the Downstream Vertical Integration and Efficiency Implications in Agricultural Cooperatives

Abstract This study investigates the explanatory variables affecting the agricultural cooperatives decision of downstream vertical integration into the transformation of the products supplied by their members. The study also analyses the effect of the vertical integration decision on the efficiency obtained. This analysis has been carried out by means of a two-step methodology suggested by Heckman (1979) over a sample of Spanish agricultural cooperatives belonging to the Qualified Denomination of Origin La Rioja. The results obtained show that those cooperatives, which have adopted Actualisation Mechanisms of social capital, high dedication to agricultural activity, and high rate of capacity utilization are more likely to integrate within the cooperative another stage of the production cycle. Furthermore, the results show that the most efficient cooperatives are those with a higher level of downstream vertical integration.

Forward Integration and Innovation: Transaction Costs and Beyond

The Transaction Cost Economics (TCE) theory developed by Oliver Williamson has provided a deep understanding of factors behind the vertical integration decisions of firms. This paper begins with a brief case study of forward integration in the early years of select industries. The analysis suggests that other factors, such as capabilities, can complement the TCE approach. The paper shows how TCE has been combined with these other concepts and the Profiting From Innovation framework to provide a more complete analytical toolkit for evaluating forward vertical integration decisions, particularly in the context of innovation.

Geographical Agglomeration as an Alternative to Vertical Integration

This paper provides empirical evidence of the relationship between agglomeration and vertical integration decisions. It contributes to the existing literature by first developing a conceptual framework that focuses on both opportunism risk and communication problems to explain how physical proximity among firms can be an alternative to internal organization. Second, this study tests this relationship through the use of firm-level data from 10,955 establishments in the Spanish meat industry. Results confirm that establishments located in agglomerated areas internally undertake fewer stages of the value chain. We also find that this relationship is weaker than expected and fades at distances greater than 2.5 km, which may be explained by the particular characteristics of this industry.

Vertical Integration to Avoid Contracting with Potential Competitors: Evidence from Bankers’ Banks

We examine a vertical integration decision within the commercial banking industry. During the last quarter of the 20th century, some community banks reduced their traditional reliance on correspondent banks for upstream products and services by joining bankers’ banks, a form of business cooperative. Research on vertical integration focuses primarily on firm-specific investment, market power, and government regulation. However, this case is difficult to explain in terms of these standard vertical integration motives. Our evidence suggests that bankers’ banks are a response to technological change and deregulation that results in increased costs faced by community banks in dealing with correspondent banks as both suppliers and potential competitors. For instance, loan participations require sharing proprietary information about major loan customers, something a community bank would not want to provide to a potential competitor.

Management innovation in supply chain: appreciating Chandler in the twenty-first century

Alfred Chandler attributed the rise of the vertically integrated corporation in the twentieth century to improvements in transportation and communication. In contrast, many have argued that further advances in transportation and communication have made vertical integration obsolete in recent years, replacing it with modularity, outsourcing, and networking. This article unpacks this apparent puzzle by regarding technological improvements in transportation and communication as theoretically neutral with respect to the degree of vertical integration. We argue that the key concepts and issues in supply chain management that Chandler highlighted remain highly relevant today. We integrate Chandler’s detailed historical perspective on the evolution of the “visible hand” of managerial governance with more recent theories from organization economics and from engineering, yielding the following insights. First, aligning incentives of buyers and suppliers is important in achieving throughput and assured supply, but asset ownership is neither necessary nor sufficient for this. Second, vertical integration (and disintegration) decisions affect the internal operation of the firm and its future path. Third, firms need to design their value chains in such a way as to achieve coordination without information overload. The article demonstrates the continuing power of these insights in three phases over the last century. In the first phase (with the rise of mass production), Chandler himself noted a subtle array of make-and-buy decisions. In the second phase (with the rise of lean production), several varieties of non-integration (e.g. exit vs. voice) persisted because of the specific ways in which firms combined incentive alignment and information flow. In the third (“New Economy”) phase, management of information and material flows through the supply chain remains an important source of competitive advantage. In particular, disintermediation as a form of vertical integration, and successful outsourcing require investment in technical expertise over a wide range of technological fields and coordination of knowledge to manage suppliers (see for example, Brusoni and Prencipe, 2001; Brusoni, 2003; Clark and Fujimoto, 1991). By noting that neither externalization through outsourcing nor flattening of managerial hierarchy is the same as decentralization, the article provides theoretical and empirical bases for the continuing importance of Chandler’s principles in managing supply chains.

Do Agglomeration and Technology Affect Vertical Integration? Evidence from Italian Business Groups

The aim of this paper is to analyse the role of technology and spatial agglomeration in decisions about vertical integration. It starts from the hypothesis that the business group, defined as a set of firms under common ownership and control, is the appropriate unit to delimit the firm’s boundary. We use information drawn from input–output tables to detect the presence of positive inter‐industry exchanges and whether or not activities in a group are vertically related. Accounting for endogeneity problems, we estimate Probit and Linear Probability models to investigate the role of technology and spatial agglomeration on vertical integration decisions empirically. Consistent with property rights theory, our results show that the technology intensity of acquirers matters for backward integration choices and, moreover, that agglomeration plays a role in vertical integration only when it operates jointly with technology.

Airing Your Dirty Laundry: Vertical Integration, Reputational Capital, and Social Networks

This article explores the relationship between an ethnic-based social network and vertical integration decisions in the laundry services industry. We find that stores in the social network are significantly less likely to vertically integrate than nonmember stores. This has three primary implications. First, the social network may be lowering the costs of using the market more than facilitating in-house production. This implies better outsourcing opportunities in a social network and may explain a documented relationship between social networks and firm economic performance. Second, institutional details of our example and the estimated relationship suggest a role for opportunism and reputation as determinants of the boundaries of the firm in a setting without asset specificity. Finally, although we provide evidence that better access to credit can increase the likelihood of vertical integration, we show that better outsourcing opportunities have a dominant effect of the social network in this particular setting. The Author 2009. Published by Oxford University Press on behalf of Yale University. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

Vertical Integration and Sabotage with a Regulated Bottleneck Monopoly

Abstract We study the vertical integration and sabotage decisions of a regulated bottleneck monopoly that sells "access" to independent firms and may own a subsidiary downstream. We extend the literature in four directions by: (i) endogenizing vertical integration and linking it with the intensity of vertical economies or diseconomies à la Kaserman and Mayo (1991); (ii) systematically studying how vertical economies and diseconomies affect the intensity of sabotage; (iii) showing that the intensity of sabotage is determined by either a standard Lerner condition augmented by the direct cost of sabotage or a relation between the market share of the subsidiary and the elasticity of the derived demand for access; and (iv) systematically examining the welfare effect of vertical integration.

The applicability of transaction costs economics to vertical integration decision: evidences from a brazilian beef processor

This article aims to explore the vertical integration decision of a beef processor from an integrated approach operations strategy and transaction costs economic theory. In this research, vertical integration as a structural decision of operations strategy determined by the occurrence of transaction costs. The paper presents one case study carried out in one beef Processor Company which illustrates the main theoretical assumptions. The results suggest that transaction costs economics helps to identify key points of major strategic decisions on vertical integration due to its behavioural perspective, reducing the effect of uncertainty and asset specificity of this decision. At the end of the paper, future research is suggested.

Vertical Integration and Sabotage with a Regulated Bottleneck Monopoly

In this paper we systematically study the vertical integration and sabotage decisions of a regulated bottleneck monopoly that sells access to independent downstream firms. Our results reconciliate a set of seemingly contradictory findings of the literature. We show that unless the monopoly's subsidiary is implausible more efficient than the independent firms, vertical integration never benefits consumers. Moreover, sabotage may prompt inefficient vertical integration. In addition, we show that the intensity of sabotage either depends on a relation between the market share of the subsidiary and the elasticity of the derived demand for access or a standard Lerner condition augmented by the direct cost of sabotage. More specifically, if the subsidiary and independent firms coexist in equilibrium, then the intensity of sabotage increases with the subsidiary's size and the intensity of economies of scope but if the monopoly optimally excludes rivals then intensity of sabotage decreases on these same parameters.

Organizational Form and Performance: Evidence from the Hotel Industry

We use a unique proprietary monthly panel data set on the operations of a large hotel firm to study the effect of vertical integration decisions on the pricing and performance (occupancy rate and RevPar) of individual hotels. Aggregate data patterns – which managers pay most attention to – suggest sizeable performance differences between franchised and non-franchised hotels. However, empirical analyses controlling for observable and unobservable characteristics show that if significant at all, such differences are economically much smaller than what mean comparisons suggest. Furthermore, once we endogenize the choice of organizational form using information about the Company’s other hotels in the same local market, the differences are both statistically and economically insignificant. We conclude that the Company chooses which hotels to franchise and to own optimally such that, conditional on hotel and market characteristics, it achieves consistent results – in terms of revenues per room, occupancy rates, and prices – on average across the two sets of hotels. Relating our results, obtained in a policy unconstrained setting, to those from studies that showed significant performance differences when firms’ choices of organizational forms were restricted by policy, suggests that policy can significantly affect firm performance and outcomes.

Complementarity Among Vertical Integration Decisions: Evidence from Automobile Product Development

This paper examines complementarity among vertical integration decisions in automobile product development. Though most research assumes that contracting choices are independent of each other, contracting complementarity arises when the returns to a single vertical integration decision are increasing in the level of vertical integration associated with other contracting choices. First, effective coordination may depend on the level of (noncontractible) effort on the part of each agent; contracting complementarity results if coordination efforts are interdependent and vertical integration facilitates a higher level of noncontractible effort. Second, effective coordination may require the disclosure of proprietary trade secrets, and the potential for expropriation by external suppliers may induce complementarity among vertical integration choices. We provide evidence for complementarity in product development contracting by taking advantage of a detailed data set that includes the level of vertical integration and the contracting environment for individual automobile systems in the luxury automobile segment. Using an instrumental variables framework that distinguishes complementarity from unobserved firm-level factors, the evidence is consistent with the hypothesis that contracting complementarity is an important driver of vertical integration choices. The findings suggest that contracting complementarity may be particularly important when coordination is important to achieve but difficult to monitor.