138 • Chapter 4 • Integration and Its Alternatives

merger. In such a situation, selling product produced primarily for internal uses to outside firms would be neither a distraction nor an activity for which the firm lacked resources. The firm’s opportunities for selling to other users of the product could still be limited by competitive conditions, however.

MAKING THE INTEGRATION DECISION

Assuming that firms get governance right, integration can prevent coordination problems and holdup. But even the most diligent central office cannot replicate the hardedged incentives of the market, or enable the integrated firm to achieve the same scale and learning economies as a market specialist. We have not yet systematically studied how these forces for and against integration trade off against one another in particular circumstances. We must do this to understand why vertical integration differs across industries (e.g., firms in the aluminum industry are generally more vertically integrated than firms in the tin industry), across firms within the same industry (e.g., Hyundai is more vertically integrated than Honda), and across different transactions within the same firm (e.g., U.S. firms tend to outsource transportation services to a much greater degree than warehousing or inventory management).

Technical Efficiency versus Agency Efficiency

The costs and benefits of relying on the market can be classified as relating to either technical efficiency or agency efficiency. Technical efficiency has several interpretations in economics. A narrow interpretation is that it represents the degree to which a firm produces as much as it can from a given combination of inputs. A broader interpretation— the one used in this chapter—is that technical efficiency indicates whether the firm is using the least-cost production process. For example, if efficient production of a particular good requires specialized engineering skills, but the firm has not invested enough to develop those skills, then the firm has not achieved full technical efficiency. The firm could achieve technical efficiency by purchasing the good in question from a market firm or by investing to develop the skills itself.

Agency efficiency refers to the extent to which the exchange of goods and services in the vertical chain has been organized to minimize the coordination, agency, and transactions costs discussed in Chapter 3. If the exchange does not minimize these costs, then the firm has not achieved full agency efficiency. To the extent that the process of exchange raises the costs of production (e.g., when the threat of holdup leads to reductions in relationship-specific investments and increases in production costs), we would classify this as an agency inefficiency rather than a technical inefficiency.

The make-or-buy decision often has conflicting implications for agency and technical efficiency. For example, when a computer maker obtains memory chips from the market, the firm may improve its technical efficiency by buying from specialized chip manufacturers. But this arrangement may reduce agency efficiency by necessitating detailed contracts that specify performance and rewards. The appropriate vertical organization of production must balance technical and agency efficiencies. Oliver Williamson, whom we encountered in the last chapter in our discussion of transactions costs, uses the term economizing to describe this balancing act.3

Williamson argues that the optimal vertical organization minimizes the sum of technical and agency inefficiencies. That is, parties undertaking an exchange along the

Making the Integration Decision • 139

vertical chain arrange their transactions to minimize the sum of production and transactions costs. To the extent that the market is superior for minimizing production costs but vertical integration is superior for minimizing transactions costs, trade-offs between the two costs are inevitable. Even the best organized firms confront the effects of this trade-off, in the form of higher production costs, bureaucracy, breakdowns in exchange, and litigation.

The Technical Efficiency/Agency Efficiency Trade-off

Figure 4.1 provides a useful way to think about the interplay of agency efficiency and technical efficiency.4 The figure illustrates a situation in which the quantity of the good being exchanged is fixed at a particular level. The vertical axis measures cost differences between internal organization and market transactions. Positive values indicate that costs from the internal organization exceed costs from the market transactions. The horizontal axis measures asset specificity, denoted by k. Higher values of k imply greater asset specificity.

The curve DT depicts the differences in technical efficiency. It measures the differences in production costs when the item is produced in a vertically integrated firm and when it is exchanged through an arm’s-length market transaction. We exclude any differences in production costs that result from differences in incentives to control costs or to invest in cost-reducing process improvements across the two modes of organization. DT is positive for any level of asset specificity because outside suppliers can aggregate demands from other buyers and thus can take better advantage of economies of scale and scope to lower production costs than firms that produce those inputs themselves. The cost difference declines with asset specificity because greater asset specificity implies more specialized uses for the input and thus fewer outlets for the outside supplier. As a result, with greater asset specificity, the scaleand scopebased advantages of outside suppliers are likely to be weaker.

FIGURE 4.1

Tradeoff between Agency Efficiency and Technical Efficiency

140 • Chapter 4 • Integration and Its Alternatives

The curve DA reflects differences in agency efficiency. It measures differences in exchange costs when the item is produced internally and when it is purchased from an outside supplier in an arm’s-length transaction. When the item is purchased from an outside supplier, these costs comprise the direct costs of negotiating the exchange; the costs of writing and enforcing contracts; and the costs associated with holdup and underinvestments in relationship-specific assets that we discussed in Chapter 3. They also include the costs of breakdowns in coordination and leakage of private information, also discussed in Chapter 3. When the item is produced internally, these costs include the agency and influence costs discussed in Chapter 3. In short, the DA curve reflects differences in agency efficiency between the two modes of organizing transactions.

The DA curve is positive for low levels of asset specificity (k , k*) and negative for high levels of asset specificity. When asset specificity is low, holdup is not a significant problem. In the absence of significant holdup problems, market exchange is likely to be more agency efficient than vertical integration because, as discussed in Chapter 3, independent firms often face stronger incentives to innovate and control production costs than divisions of a vertically integrated firm. As asset specificity increases, the transactions costs of market exchange also increase, and beyond a critical level, k*, these costs are so large that vertical integration is more agency efficient than market exchange.

The curve DC is the vertical summation of the DA and DT curves. It represents production and exchange costs under vertical integration minus production and exchange costs under market exchange. If this curve is positive, then arm’s-length market exchange is preferred to vertical integration. If the curve is negative, the exchange costs of using the market more than offset the production costs savings, and vertical integration is preferred. As shown in Figure 4.1, market exchange is preferred when asset specificity is sufficiently low (k , k**). When asset specificity is greater than k**, vertical integration is the preferred mode of organizing the transaction.

Vertical integration becomes increasingly attractive as the economies of scale in production become less pronounced. To see this point, recall that the height of the DT curve reflects the ability of an independent producer to achieve scale economies in production by selling to other firms. Weaker economies of scale would correspond to a downward shift in DT and DC, which in turn results in a wider range in which vertical integration is preferred to arm’s-length market contracting. In the extreme case, as economies of scale disappear, the DT curve coincides with the horizontal axis, and the choice between vertical integration and market procurement is determined entirely by agency efficiency, that is, the DA curve.

Figure 4.2 shows what happens to the choice between market contracting and vertical integration as the scale of the transaction increases. There are two effects. First, the vertically integrated firm could now take fuller advantage of scale economies because it produces a higher output. This reduces the production-cost disadvantage of internal organization and shifts the DT curve downward. Second, increasing the scale of the transaction accentuates the advantage of whichever mode of production has lower exchange costs. Thus, the DA curve would “twist” clockwise through the point k*. The overall effect of these two shifts moves the intersection point of the DC curve to the left, from k** to k***. (The solid lines are the shifted curves; the dashed lines are the original curves.) This widens the range in which vertical integration is the preferred mode of organization. Put another way, as the scale of the transaction goes up, vertical integration is more likely to be the preferred mode of organizing the transaction for any given level of asset specificity.