Vertical Integration and Technological Innovation

A Transaction Cost Approach

Yeong Heok Lee

• Publisher: Routledge
• Year: 2018
• ISBN:
  9780429852169
• Edition: 1
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

Originally published in 1994 this volume investigates the relationship between a firm's decision to integrate vertically and its research and development (R & D) strategy. Literature on vertical integration is reviewed and a framework presented to analyze the costs and benefits of vertical integration. The theoretical basis for the proposed hypostheses is investigated and the hypotheses tested empirically.

I

Introduction

1.1  RESEARCH MOTIVATION

The purpose of this study is to investigate the relationship between a firm’s decision to integrate vertically and its research and development (R & D) strategy. As a modern economy grows and technology develops rapidly, technological competition between rival firms has become more severe. While there are many different means by which a firm to obtain a technological advantage, one of the more important ways is how it reorganizes itself to conduct or absorb technological knowledge. One of these means is vertical integration.

Vertical integration changes not only the number of products produced by a firm, but also involves changes in all the resources of a firm such as human resources, manufacturing facilities, and stock of technological endowment, and changes in their functions within a firm. A firm’s decision to integrate vertically may not depend on any instant and short-term beneficial effects or cost savings. Rather the managerial decision for vertical integration may represent a comprehensive and future-oriented strategy designed to improve the firm’s global environment for future progress. This view of vertical integration as a long-term management strategy leads to an examination of its relation to research and development activity, because R & D is more frequently characterized by uncertainty and a longer-range objective. The strategic coincidence of vertical integration and technological innovation is implied by the following remark from Friar and Horwitch (1985):

Technology strategy has intimate ties with the other functional strategies of a corporation, including marketing, manufacturing, finance, and human resources. Moreover, it has a profound impact on the business strategies of a firm, such as in creating synergies between businesses, in extending or transforming the life cycles of various products, or in creating opportunities for forward and backward vertical integration. (p. 145)

Unfortunately this insight has not been considered in most of the literature on vertical integration.¹ Thus, we are motivated to investigate whether or not vertical integration is related to R & D activity. In this research, we ask two basic questions: (1) is vertically integrated firm structure a “good” environment to increase the productivity of R & D activity? and (2) does the firm that expects to have more future innovation integrate vertically more so than other firms? Therefore, the tasks of our study are to combine two different fields of economics -- vertical integration and technological innovation; to relate them; and to examine any possible simultaneous feedback effect between them.

The theory of vertical integration² has been studied in the context of the theory of the firm. After Coase (1937) defined the difference between a firm and a market in terms of transaction costs, Williamson (1975) set up the basic theory of transaction cost economics. The transaction cost approach to vertical integration is used in this paper, since transaction cost can explain many rationales for vertical integration.

While the relationship between market structure and innovation has been a common research topic in the study of technological innovation, the study of the firm-specific effects of technological innovation -- which is the study of environmental firm-specific effects inside the black box of R & D activity -- is still at a formative stage. The traditional argument concerning the relationship between market structure and a firm’s R & D activity centers on the scale economies in R & D. According to the “Schumpeterian hypothesis,” a larger firm’s R & D activity is more intensive than a smaller firm’s because the larger firm’s R & D generates a greater return than the smaller firm’s. That is, because they expect that the productivity per dollar of research expenditure will increase as size grows, such firms will devote more resources to R & D compared to their sizes. While a lot of work has been done in this field, there remains a considerable debate over the empirical evidence to support this view.³

In this dissertation we propose that the vertical integration, rather than the size of a firm, generates a greater return on the firm’s R & D through what we term the “knowledge complementarity” effect. In addition, we hypothesize that a firm decides to vertically integrate because such integration can mitigate the market transaction costs associated with expected future innovation. The reason why the firm does not use the external market for its future innovation, namely why the firm emphasizes internal R & D through vertical integration rather than uses technology licensing or R & D contracting, will be explained in a transaction cost context.

1.2   RESEARCH OVERVIEW

After the introduction (chapter 1), we review the literature on vertical integration and present a framework to analyze the costs and benefits of vertical integration in chapter 2. In chapter 3 we investigate the theoretical basis for our main hypotheses, and in chapter 4 we test the hypotheses empirically.

As we develop our arguments in the context of transaction cost economics, we adopt the basic concept that no externality effect exists in the strict sense. This concept means that all externalities would be eliminated by bargaining, while the bargaining accompanies transaction costs. This is because the existence of externalities implies that bargains could be made that would improve the welfare of all concerned, as Warren-Boulton (1978) indicated. The notion that the same effect with externalities can be obtained through bargaining in the external market will be the starting point for our cost-benefit analysis of vertical integration.

The two basic tools necessary to relate vertical integration and technological innovation are the knowledge complementarity effect⁴ and transaction costs. Knowledge complementarity explains the mechanism by which vertical integration helps innovative activity, and transaction costs explain the reason why vertical integration, rather than the external market, is used for efficient future innovation.

The terminology of “knowledge complementarity effect” represents “informational economies” in knowledge production. The knowledge complementarity effect of vertical integration means that upstream and downstream production processes within a firm use some common knowledge and provide relevant information to help one another become more efficient in R & D. Transaction costs are the costs of organizing economic activity, not the costs of producing real products. The transaction costs of technology licensing or R & D contracting occur due to the information asymmetry problem in technology-related transactions. Technology buyers necessarily know less about the technology than the sellers, because the information about the technology is the product itself. Chapter 3 develops these two concepts in detail.

Chapter 4 presents empirical evidence for the arguments addressed in the initial chapters. The evidence is based on a study of vertical integration and technological innovation in the U.S. electronics industry. The empirical test featuring the assumptions and technique of the rational expectations hypothesis uses a dynamic simultaneous equation model with expectation variables and various time lags.

Concluding remarks appear in chapter 5 along with some suggestions for future research.

Notes

1.  An exception is Armour and Teece (1980) who argued that the more vertically integrated firm would be more efficient in R & D than the less vertically integrated firm. But they did not explain the strategic coincidence or simultaneity effect between vertical integration and R & D strategy.

2.  Vertical integration means the extent to which a firm carries on the production processes from raw materials to final product in itself. The terminology of vertical integration should be used differently from the behaviour like vertical merger. Vertical integration is achieved through vertically merging another firm or building new input-producing plant.

3.  Scherer’s review of the empirical evidence pointed to a threshold effect: up to a certain level of size, the larger firm’s R & D generates a greater return than the smaller firm’s, but beyond that level further bigness added little or no increase on the rate of return (Scherer, 1980, p. 422).

4.  We use knowledge interchangeably with information in this study, while knowledge is the contents and information refers to the process of knowledge transfer. Since knowledge is a valuable product to be transacted in the market, We exclude the notion of negative knowledge. According to Machlup (1980), the members of the negative knowledge set are erroneous knowledge, contradicted knowledge, obsolete knowledge, rejected knowledge, questionable knowledge, uncertain knowledge, vague knowledge, illusive knowledge, confusing knowledge, and so on.

II

Costs and Benefits of Vertical Integration

2.1 TRANSACTION COST APPROACH TO VERTICAL INTEGRATION

2.1.1 Various Rationales for Vertical Integration

Most of the literature on vertical integration to date has focused mainly on two sets of motives: market power and efficiency. In market power considerations, the purpose of a firm’s vertical integration was either to gain extra profit through price discrimination, or to forestall entry through market foreclosure or denial of material supply. Perry (1980) found that forward integration by Alcoa was done mainly for the purpose of price discrimination. Crandall (1968) explained the backward integration of motor vehicle producers with price discrimination and market foreclosure. Allen (1971) examined the market foreclosure complaint against the vertical integration of a cement company and a producer of ready-mixed concrete. While the courts have raised several objections to vertical integration based upon antitrust law, most economists could not find much support for the notion that vertical integration was generally used for anticompetitive purposes. In order for the integrating firm to succeed in price discrimination or to forestall entry through vertical integration, the integrated firm must already have had some market power in its product market.

While market power considerations do not sufficiently explain vertical integration, efficiency considerations have received a great deal of attention from economists. The most popular explanation concerned economies of scope between successive stages due to technological and organizational interrelationships (Bain, 1959; Chandler, 1966).¹ Other arguments have dealt with the avoidance of factor distortions in a downstream firm’s production when monopolistic input supply is integrated to a downstream production process (Vernon and Graham, 1971; Warren-Boulton, 1974); a downstream firm’s information acquisition about the uncertainty of an upstream goods’ supply (Arrow, 1975); the transfer of uncertainty from a downstream firm to an upstream firm (Carlton, 1979); and the avoidance of demand variability (Bernhardt, 1977). Furthermore, it has been pointed out that transaction costs might create important incentives for vertical integration (Coase, 1937; Williamson, 1975). Recently, many economists have emphasized transaction costs as a rationale for vertical integration and have tested them empirically (Monteverde and Teece, 1982; Mowery, 1983; Anderson and Schmittlein, 1984; Masten, 1984; Levy, 1985). We will develop our hypothesis on efficiency considerations, which is centered on the transaction cost argument.

2.1.2 Transaction Cost Approach to Vertical Integration

The theory of transaction cost economics goes back to the era of Coase(1937). When he answered “why a firm emerges at all in a specialized exchange economy,” he cited transaction costs as the reason. He identified a transaction cost as “a cost of using the price mechanism”(p. 390). The costs of organizing production through the price mechanism are those stemming from the discovery of what the relevant prices are; from negotiating and concluding a contract; from a lack of flexibility associated with long-term contracts; and from a sales tax on market transactions. After he mentioned the cost of transacting within a firm (internalization cost) as “diminishing returns to management,” Coase summarized the reason for a firm’s emergence in one paragraph:

A firm will tend to expand until the costs of organizing an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organizing in another firm. (p. 395)

Since then, this remark has been the subject of all the transaction cost studies. We will also develop our arguments within this boundary.

In his famous book, Markets and Hierarchies (1975), Williamson located the sources of transaction costs in the characteristics of human nature. These characteristics are labeled “bounded rationality” and “opport...