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september · december 2005 · esic market

Ve rtical integration, market i m p e rfections, firm attributes and industry changes Isabel Díez Vial

Departamento de Organización de Empresas

Facultad de Ciencias Económicas y Empresariales

Universidad Complutense de Madrid

Abstract

This study analyses the main reasons for vertical integration from four pers -pectives: the industrial organization, the new institutional economics, there s o u rce-based view and dynamic vertical integration models. For each ofthese, we identify the hypotheses developed, the measures used and the cha -racteristics of the existing empirical evidence. On the basis of this re v i e w,we conclude that vertical integration decisions involve a simultaneous con -sideration of the industry ’s characteristics and the market power diff e re n c e sthat exist between the phases involved, the attributes of the transactionsbetween stages and their consequences upon the efficiency of vertical inte -gration, the re s o u rces owned by the company and their applicability alongthe value chain and, lastly, the appearance of innovations in the industrywhich alter the way in which the production process is org a n i s e d .

Key words: Theoretical review, specific assets, resources and marketpower.

JEL Code: L14, L15, L22, M20.


vertical integration, market imperfections,firm attributes and industry changes

1. Introduction

Factors that lead companies to vertically integrate, thereby undertakingactivities in the production cycle which could be contracted in the market,have been largely explained by the existence of failures in the intermedia-te markets which relate the production activities (Fuente & Hernangomez,1990). Most studies have associated vertical integration with marketimperfections which are either due to differences in market power (Contín& Huerta, 2000) or information asymmetries and opportunism amongindependent clients/suppliers (Williamson, 1985)1.

Nonetheless, recent resource-based view studies have found other rea-sons based on the capabilities, knowledge and experience that the com-pany possesses. Vertical integration is then understood as a diversificationstrategy, so firms undertake new stages of the value chain to exploit theirresources (Argyres, 1996, Camisón & Guía, 1999). Similarly, several aut-hors have highlighted the importance of analysing vertical integrationfrom a dynamic perspective, taking into account the changes that innova-tions introduce on the existing capabilities of the industry in which thecompany operates (Robertson & Langlois, 1995; Teece,1996).

The main objective of this study is to analyse the reasons for verticalintegration, taking into account all these different and sometimes compe-ting approaches. A framework is established which facilitates the unders-tanding of vertical integration whilst also identifying the conditions underwhich companies that extend their limits may improve their efficiency.Despite the great interest aroused by the subject of vertical integration,there are few works which deal with these new contributions. However,there is no doubt that studies which consider different approaches are ofgreat use both to managers, in that they facilitate decision-making, and toresearchers, in that they identify new research opportunities. As indicatedby Mahoney (1992: 559): “In order to perform future studies in this field,it is essential to establish a unified conceptual body, above all from withinthe field of strategic management, which integrates contributions fromvery different fields into its studies”.

(1) The following works

review the existing

literature using these

two approaches: Joskow

(1985) and Rindfleish &

Heide (1997), for

opportunism problems;

Blair & Kaserman

(1983), Perry (1989),

Waterson (1993) for

power differences, and

D’Aveni & Ravenscraft

(1994) or Mahoney

(1992), for both.

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To this end, the reasons for vertical integration are divided into fourmain groups, according to the four most significant study approaches: thedifferences in market power between different production process phases(industrial organization), the risk of opportunistic behaviour in relationswith suppliers or clients (new institutional economy), the resources, capa-bilities and knowledge that the company possesses (resource-based view)and the models based on the industry’s evolution. Each of these motives isassessed in terms of contributions, significant factors, and existing empiri-cal evidence (see Table 1).

2. Power differences between phases and industrial organization

The industrial organization uses the production value chain stages as theunit for analysis in order to explain vertical integration as being due to the existence of production process phases with market power. A companywill vertically integrate to reduce the market power of suppliers and clients(Stuckey & White, 1983; García Vazquez, 1996). If a company must payhigh prices when purchasing raw materials or is forced to sell its productsbelow the competitive price, it will vertically integrate. In doing so, firmsnot only reduce the power of its suppliers or clients but also obtain anadvantage over its non-integrated rivals (Aburi et al., 1998). This incenti-ve to vertical integration is even greater when not only the supplier orclient has market power, but also the company itself. These conditionsproduce an excessive concentration of power in the production cyclewhich reduces extraordinary income, rather than increasing it (Hamilton& Mqasqas, 1996). This is the well-known situation of “successive mono-polies”, in which companies in each phase set the price and amount to beoffered, taking into account their own profit but not the negative effectthat this may have upon companies in other phases. It is also the case of a“bilateral monopoly”, in which two phases have power over the sameintermediate market and in which a competitive situation would be moreprofitable, regardless of the negotiating power of each party (Scherer &Ross, 1990).

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A second reason for vertical integration is to recover the extraordinaryrents lost by certain companies due to the substitution of their products byother alternatives, even though these substitutes are less efficient (Warren-Boulton, 1974). When faced with the possibility that purchasing compa-nies may substitute a product (their raw material), the company has twooptions, it may either reduce the price of the product in order to discou-rage its replacement, which would entail the loss of extraordinary rents,or it may integrate vertically (Mallela & Nahata, 1980). In the latter case,the company would find itself competing with its clients for the sale of thefinished product but would have lower production costs. Thus, the inte-grated company would obtain cost benefits in the final market whichwould enable it to recover the income lost as a result of the substitution ofits product/raw material in the initial phase (Abiru, 1988).

Lastly, companies vertically integrated in order to increase their mar-ket power, thereby eliminating existing rivals and discouraging the entryof new competitors. A company which possesses market power in onephase and insources an adjacent product process phase then becomes asupplier or client to its rivals in the phase in which it was initially opera-ting. This double presence in the production cycle allows the integratedcompany to increase its rivals’ costs and force them to reduce their mar-ket presence (Salop & Scheffman, 1983). The anti-competitive strategiesthat an integrated company may use in order to increase its rival’s costsare the following: raising the price of the raw materials (Perry, 1989),excluding a considerable share of raw materials from the market(Kratttenmaker & Salop, 1986), facilitating collusion between the non-integrated supplying companies (Ordover et al., 1990) and creatingincompatibilities between its own technology and that of its rivals (Church& Gandal, 2000).

The studies carried out under this approach have tended to constructeconomic models focused more on vertical integration consequences interms of social welfare, rather than on business profitability. Moreover,most authors have based on quite unrealistic extreme situations of per-

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fectly competitive or monopolistic phases, so conclusions must be care-fully interpreted. It is for this reason that relatively few studies havecarried out an empirical evaluation of the relationship between concen-tration and/or collusion, important explanatory factors, and vertical inte-gration, with the vast majority of them providing confirm a t i o n(Lustgarten, 1975; Tucker & Wilder, 1977; Levy, 1984; MacDonals,1985; Spiller, 1985; Huerta, 1986; Martin, 1986; Caves & Bradburg,1988; Chatterjee, 1991; Azzam, 1996; Contín & Huerta, 2000).

3. The risk of opportunistic behaviour among suppliers

and clients: The new institutional economics

The new institutional economics explains vertical integration as the resultof imperfections in intermediate markets which are due to informationasymmetries and opportunism. Taking as unit of analysis the relationshipbetween two stages of the value chain, or “transaction”, vertical integra-tion is defined as a coordination form alternative to market relationships(Williamson, 1991). Two situations are identified in which market rela-tionships are replaced by vertical integration: when specific assets anduncertainty exist – hold-up problem –; and when the product exchangedbetween the stages is difficult to evaluate– moral hazard risk –. In bothcases, independent providers or clients can behave opportunistically andmarket relationships can only reduce this risk by incurring high negotia-tion, information and monitoring costs (Alchian & Woodward, 1988). Bycontrast, a vertically integrated company takes decisions in a co-ordinatedway through hierarchical relationships, so opportunism is reduced bymeans of direct monitoring and rules of conduct (Hömstrom & Milgrom,1994).

The presence of specific assets and uncertainty2 in market relationshipsintroduce hold-up risk in the relationship. Since the presence of specificassets prevents the investor from leaving the relationship without incu-rring in high costs, the non-investing party may take advantage of thisdependence by behaving opportunistically. This problem could be resolved

(2) Along with

specificity and

uncertainty, the

transaction is assumed

to occur frequently since

only then it is worth

establishing a company

governance structure. In

contrast to the other two

characteristics,

frequency is usually

assumed, so it is barely

contrasted (Rindfleisch

& Heide, 1997: 31). As

an exception, Eccles

(1981), Anderson &

Schmittlein (1984),

Anderson (1985),

Globerman & Schwindt

(1986) and Dahlstrom &

Nygaard (1993) do

include it in their

studies.

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by elaborating a complete contract, so all possible future contingenciesand their resolution would be included. Nevertheless, the existence ofuncertainty makes such a solution very costly and sometimes impossible -the parties have bounded rationality (Masten, 1984; López-Bayón et al.,2002).

In other cases, it is the difficulty of evaluating the real characteristicsof the good exchanged in the transaction that introduces opportunisticrisk –moral hazard risk–. There arises informative asymmetries betweenthe stages of the value chain, favouring the provider of the good, who canreduce his efforts, use lower quality inputs or simply give false informa-tion about the good (Arruñada, 1998). Other than through direct control,the buyer of the good can only reduce this problem by either incurring inhigh inspection costs (Barzel, 1982) or establishing a contract which incor-porates complex but incomplete approximate measurements of the desiredcharacteristics of the good (Klein & Murphy, 1997).

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Table 2. Investment in specific assets and their relationship with vertical integration

Caves & Bradburd (1988)83 supplying industries

Suppliers of intermediate goods– Buyers

Many industries

ObjectiveVolume of assets invested in industry (+)

Coles & Hesterly (1998)195 transactions

Hospitals - 15 different servicesHospital sector

ObjectivePhysical (+): specifically-designed equipment and its salvage value;

Human (+): level of prior training and coordination

Globerman & Schwindt (1986)Descriptive

Forests – Forestry operations –production of wood pulp-paper

Forestry industryLocation (+); applied (+); physical (+)

Gonzalez-Diaz, Arruñada &Fernández (2000)1010 transactions

Companies–26 different activities

Construction sector

ObjectiveInverse of number of companies in the phase (+)

Hennart (1988)Descriptive

Bauxite extraction - refiningAluminium industry Physical, location (+)

John & Weitz (1988)87 industrial companies

Company – sales forceMany industries

SubjectiveHuman (+): level of prior training

Klein, Fraizier & Roth (1990)375 companies

Way of marketing products elsewhere

Many industries

SubjectivePhysical (+): specific installations; Human (+): Nature of product

of company or specific information, learning

Levy (1985)69 companies

None in particular37 different industries

ObjectivePhysical proximity (+), advertising (+), R+D investment (+)

Mariotti & Cairnaca (1986)Descriptive

None in particularTextiles industry Physical (+), human (+)

Masten (1984)34 transactions

Components purchasingAeronautical sector

SubjectivePhysical (+): whether component used in other company or not;

location (+): whether physical proximity is important for produc-tion or not

ARTICLE ANALYSED TRANSACTIONSECTOR

ASSET MEASUREMENTS (RELATIONSHIP)

Anderson (1985)159 sales departments Manufacturers – Sales force

Electronic components industry

SubjectiveHuman (+): procedures level, products, information, specific natureof client or company, degree of loyalty, importance of key accountsAnderson & Schmittlein (1984)

145 component lines



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Source: Prepared by authors.

Table 2. C o n t i n u e d .

Masten, Meehan & Snyder(1989)

118 transactions

Components purchasing?Car sector

SubjectivePhysical (-): specific physical components; human (+): technological

knowledge; Location (+): importance of physical proximity

Masten, Meehan & Snyder(1991)

74 transactions

Components purchasingAeronautical sector

SubjectivePhysical (+): adapted installations; human (+): specific attributes,

knowledge and workers; temporal (+): synchronisation

Mitchell (1976)Descriptive

Oil extraction - refiningOil sector

Location (+)

Monteverde (1995)23 companies

Product design - manufactureSemiconductor industry

SubjectiveProcedure-related (+): non-structured technological knowledge

Murray & Kotabe (1999)100 companies

Companies – servicesMany service industries

Subjective Level of specific attributes, equipment and “know-how” (+)

Poppo & Zenger (1998)152 companies

Company- Information systemsMany industries

Subjective Cost of changing to alternative relationships (+)

Robertson & Gatignon (1998)264 companies

Company – technological development

Many industries

Subjective Degree of specific marketing, technology, financial investment,

equipment and learning (+)

Teece (1976)Descriptive

Oil extraction - refiningOil sector

Location (+)

Walker & Weber (1984, 1987)60 decisions

One company –componentsCar sector

Subjective Inverse of number of suppliers (+)

Zaheer & Venkatraman (1994)120 agencies

Insurance firms - agenciesInsurance sector

Subjective Procedure-related (+): specific flows, training and attributes

Monteverde & Teece (1982a)18 transactions

Monteverde & Teece (1982b)133 transactions

Components purchasingCar sector

Subjective and objectivePhysical (-): cost of tools* level of specialisation

Subjective Human (+): technological knowledge

ARTICLE ANALYSED TRANSACTIONSECTOR

ASSET MEASUREMENTS (RELATIONSHIP)



Extensive empirical evidence has verified the relationship betweenthese factors and vertical integration. As shown in Table 2, results indica-te that vertical integration increases when specific assets are present, mea-sured either by the existence of different types of assets – physical, human,location or capability-related (Anderson, 1985; John & Weitz, 1988;Masten et al., 1989; Coles & Hesterly, 1998; Murray & Kotabe, 1999),the cost of change in the relationship (Monteverde & Teece, 1982a; Poppo& Zenger, 1998) or the number of alternative transactions (Walker &Weber, 1984; Gonzalez-Díaz, et al., 2000).

By contrast, the effect of uncertainty, measured by variations indemand, technology or the degree of complexity of the relationship, is notclear (see Table 3). Whereas certain studies confirm a positive relationshipwith vertical integration (Anderson, 1985; John & Weitz, 1988; Coles &Hesterly, 1998), others find the effect to be negative (Harrigan, 1985;Macmillan et al., 1986; Lieberman, 1991; Sutcliffe & Zaheer, 1998) ornon-significant (Anderson & Schmitlein, 1984; Murray & Kotabe, 1999;Poppo & Zenger, 1998; Robertson & Gatignon, 1998). The main reasonfor this lack of significance is that many papers tend to consider the effectof uncertainty without measuring the degree of specific assets existing inthe relationship. In consequence, it could be that firms do not invest inspecific assets, in this way avoiding opportunism risk while taking advan-tage of their higher flexibility in the presence of uncertainty (Shelanski &Klein, 1995).

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Table 3. Relationship between uncertainty and vertical integration

Anderson (1985)*159 sales departments

Demand-related (Subjective)9 items on unpredictability of new products and markets

+(AE)

ConfirmedLogit

Anderson & Schmittlein (1984)*145 electronic component lines

Demand-related (Objective)Deviation between predictions and real sales figures

+ Not significantLogit

Balakishnan & Wernerfelt(1986)

93 industries at 4 SIC level

Technological (Objective)Inverse of average obsolescence of technology in industry-

ConfirmedOrd. least squares

Caves & Bradburd (1988)83 industries

Demand-related (Objective)F of regression of production changes over that of their

clients-

Contrary to expectationsLinear regression

Coles & Hesterly (1998)2900 transactions

Technological (Subjective)1 item: Introduction of new methods or technologies

+(AE)

Partially confirmedLogit

Dahlstrom & Nygaard (1993)2370 petrol stations

Primary (Objective)Standard deviation of monthly prices

+ Not significantOrd. least squares

Harrigan (1985)111 business units

Demand-related (Objective)Sales growth (%) (inverse) & average dispersion of sales

growth in 5 years-

ConfirmedDelphi & regression models

John & Weitz (1988)*87 companies

Demand-related (Subjective)5 items on unpredictability of volume of activity

+ ConfirmedLogit

Klein, Frazier & Roth (1990)510 Canadian export companies

Demand-related (Subjective)(+) 3 items on volatility of unexpected changes in context (-)

3 items on diversity in origin of changes+/-

ConfirmedMultinomial logit

Levy (1985)*69 manufacturing companies

Demand-related (Objective)Error variance of regression logarithm of sales over temporal

tendency+

ConfirmedOrd. least squares

Lieberman (1991)34 chemical products

Demand-related (Objective)R2 of regression of company production over time

-Not significantBinomial logit

Macmillan, Hambrick &Pennings (1986) *

PIMS data for four years

Demand-related (Objective)Average absolute deviation of market sales in relation to mar-

ket growth rate -

Partially confirmedOrd. least squares

ARTICLE H ASSET MEASUREMENTS (RELATIONSHIP)RESULTSStatistics



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Table 3. C o n t i n u e d

Masten (1984)*34 transaction in aerospace

industry

Complexity (Objective)Variable dummy for each type of component

+ ConfirmedMaximum probability

Masten, Meehan & Snyder(1991)*

74 transactions in aerospaceindustry

Complexity (Subjective)Scale of component or task complexity level

+ Partially confirmedCensured regression

Murray & Kotabe (1999)100 service companies

Demand-related (Subjective)1 item on level of demand uncertainty

+(AE)

Not significantModerate regression

Muris, Scheffman & Spiller(1992)

Relationship between soft drinksmanufacturers and distributors

Primary (Subjective)Number of promotions, variety of products and packaging

formats, complexity of strategies…etc.+

ConfirmedCase studies

Poppo & Zenger (1998)152 computer service companies

Technological (Subjective)2 items: level of rapid change in attributes and HW & SW ?

Not significantOLS & Probit

Sutcliffe & Zaheer (1998)Scenario method with 308 MBA

students

PrimaryChanges in unemployment rate, economic growth

or inflation rates?

Negative relationshipHierarchical regression

Walker & Weber (1984, 1987)*60 transactions in a car manu-

facturing company

Demand-related (Subjective)2 items: variability and unpredictability of volume of demand

+

Technological (Subjective)2 items: probability of changes in components or product

+

ConfirmedLISREL and ord.

least squares

Not significantIdem

Robertson & Gatignon (1998)264 companies

Demand-related (Subjective)2 items on degree of unpredictability

+ Not significantLogit

Technological (Subjective)6 items on speed of technological change

-Confirmed

Logit

ARTICLE H ASSET MEASUREMENTS (RELATIONSHIP)RESULTSStatistics

H= Sign considered in the hypothesis (hypotheses) regarding relationship between uncertainty and vertical integration.Source: Prepared by author, based on Mahoney (1992) *= Articles compiled by this author.



Lastly, there are also many studies which have analysed and verifiedthe positive relationship between measurement problems and vertical inte-gration. Anderson (1985), Anderson & Schmittlein (1984) and John &Weitz (1988) find a greater tendency to use direct sales forces. Robertson& Gatignon (1998) observe that the greater the difficulty in measuring theresult of the innovation, the greater the tendency to develop innovationsinternally. Poppo & Zenger (1998) partially confirm a lesser tendency tooutsource computer services when it is difficult to verify the efforts of thepeople providing them. However, many of the studies are based on theagency theory, so they associate measurement problems with the type ofcontract that must be created rather than the type of organisation –verti-cal integration or market relationship– (See Kraff, 1999).

4. The resource-based view, similarity

and comunication between phases

The resource-based view explains vertical boundaries according to thefirm internal pool of resources (Foss, 1993). Firms vertically integrate tobetter exploit their heterogeneous and unique resources since they are noteasily transferable to other company – imperfect mobility (Teece, 1982;Chatterjee & Singh, 1999). However, in order for the firm to undertakeanother stage of the value chain it is also necessary for the resources requi-red in the different production stages to be similar, so that a companywhich is good in one phase will also be good in the phases that it insour-ces (Mahoney & Pandian, 1992).

Richardson (1972) was the first to highlight that the phases of the pro-duction process, besides being complementary in that a supplier-clientrelationship exists, are similar in the sense that they use similar capabili-ties and resources. Whereas complementarity has been widely studied bythe transaction cost theory, similarity was somewhat overlooked until thedevelopment of the resource-based view. Nonetheless, the simultaneoususe of both is extremely useful in explaining vertical integration. In theirstudy of a car company Walker & Weber (1984) show that the similarity

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between tools, experience and knowledge of different stages has a greaterinfluence than transaction costs. Similarly, Argyres (1996) carried out casestudies of fourteen insourcing decisions and found that both specific assetsand human resources –experience and organisational skills– similar tothose that the firm already possess explain make-buy decisions.

In the same way, there are several studies that understand vertical inte-gration as any other direction of diversification, so they compare the effectof similarity, or “relatedness”, on several directions of firm growth(Markides & Williamson, 1996). Their main findings indicate that simila-rity is a more powerful explicative factor in horizontal diversification thanin vertical diversification, but in any case it is necessary to take it intoaccount for understanding vertical boundaries (Hoskinsson, 1987;Lubatkin & Chatterjee, 1994). Nevertheless these studies use measure-ments of similarity among activities not quite adequate for evaluating thevertical relatedness. They understand similarity as having the same kind ofclients, cost stru c t u re or advertising expending (Lemelin, 1982;MacDonald, 1985). These measurements are appropriate for horizontally-related businesses, but not vertically-related ones since in the latter case itis preferable to analyse the similarity of the tools, knowledge or experien-ce necessary for the phases (Jacobides & Hitt, 2003).

Besides studies that view vertical integration as a direction of diversifi-cation that allows firms to use their resources among similar phases of thevalue chain, there is another kind of studies which focus on one resourcein particular, knowledge. Under this approach, vertical integration existsbecause of its higher efficiency in generating and conveying knowledgethroughout the different phases of the value chain (Grant, 1996). Eachagent possesses specific knowledge, consequence of his previous experien-ce and training, so coordinating and integrating these different personsthrough market relationships would imply high communication and trai-ning efforts (Madhok, 2002).

Within the same firm, agents can more easily learn from one anotheras they share the same common language. Since the relationship between

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agents in the same company is constant and stable, organisational routi-nes, specific codes and internal language which facilitate mutual unders-tanding are generated (Foss, 1996). Furthermore, companies can use hie-rarchy to transmit knowledge. In many cases it sufficient for the agent thatpossesses the knowledge to convert his knowledge into instructions andrules which all company members will understand and fulfil at very littlecost - “direction replaces education”, Demsetz, 1988: 157-158 (Conner &Prahalad, 1996).

There is little empirical evidence for this knowledge approach and itgenerally tends to resemble specific asset situations since various studiesexplain the positive relationship between specific assets and vertical inte-gration as being due to advantages in firm knowledge communication rat-her than transaction costs (Masten et al., 1991; Poppo & Zenger, 1998).Monteverde (1995), however, confirms the existence of improvements incommunication for the semiconductor industry, finding that a “non-struc-tured technical language” is generated between the design and manufac-turing stages which is positively associated with vertical integration.

5. Changes in the industry: economies of scale and innovation

In addition to the aforementioned theories and approaches, there existseveral studies which take a dynamic perspective analysing vertical inte-gration as a response to changes in the industry in which firms operate.The first model to perceive the analysis of vertical integration in this wayis the work of Young (1928) and Stigler (1951) who, on the basis of theSmith’s theorem (1776) which establishes that “the division of labour islimited by the extent of the market”, relate the degree of vertical integra-tion among firms with the volume of demand in the industry.

These authors believe that the production process consists of differentphases or functions, each one with an optimum production volume whichcannot be all supplied by one single company without generating capacityimbalances and greater production costs than necessary. For this reason,n o n - v e rtical integration is a more efficient organizational form .

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Nonetheless, in the emerging of the industry there are neither suitable suppliers nor demand enough -“industries are strangers for the economicsystem” (Stigler, 1951:190)-, and firms must be vertically integrated whenthey initiate their activities. It is only as demand grows so specialised com-panies enter the industry that firms can disintegrate. This process is inver-ted when the industry declines, with the resulting contraction of demand,at which time companies begin to vertically integrate as the specialisedfirms disappear.

The empirical evidence for this model is limited to a few studies whichrelate the degree of vertical integration in an industry to changes in thecompany and/or industry size (Edgar, 1977; Tucker & Wilder, 1977; Levy,1984). Nonetheless, several studies use this model as the theoretical basisfor an explanation of the negative relationship between the scale of pro-duction and vertical integration (Levy, 1985).

Robertson and Langlois (1995) develop another model that incorpora-tes into the vertical integration decision the existence of transaction costsand differences in the resources3 owned by each company, in addition tothe scale of production. Within the evolution of the industry, they distin-guish between stages of little technological change, in which vertical inte-gration tends to disappear, and stages of great change, in which verticalintegration may or may not increase, depending on the type of innovationinvolved.

Stages of little technological change are characterised by a gradualreduction in measurement and transaction costs because companies learnto draw up more comprehensive contracts with their suppliers or clients,anticipating a growing number of possible contingencies. Similarly,agents behave in a more routine and established way, which makes eva-luation easier and reduces measurement problems (Langlois, 1992a).Thus, vertical integration is in the long run just determined by the diff e-rence in the re s o u rces owned by each company and their possible appli-cation in similar phases. Firms vertically integrate to internally exploittheir re s o u rces among stages as it is very costly, or even impossible, to

(3) Following the work

of Richardson

(1972:888), the authors

use the term

capabilities, rather than

resources, to refer to the

company’s knowledge,

attributes and

experience or, in other

words, knowledge-based

resources.

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transmit these re s o u rces and the knowledge that underlies to anotherc o m p a n y. As time goes by firms’ knowledge diff e rences tend to disappe-ar so vertical integration is no more necessary (Langlois & Robert s o n ,1995: 32-34).

If this stage is interrupted by the appearance of a systemic innova-t i o n4 which involves changes in several phases of the production pro c e s s ,v e rtical integration will once again increase (Langlois, 1992b; Foss,1993; Teece, 1996). This is initially due to the greater risk of opport u-nistic behaviour arising from appropriation problems re g a rding theinnovation – the absence of pro p e rty rights for the innovation or exces-sive dependence on complementary assets (Teece, 1986). Secondly, inter-nal development is preferable due to the high cost of explaining and con-vincing other agents in the production cycle of the innovation’s success,as they may be either sceptical about the profitability of the innovation,or reluctant to substitute their assets which become obsolete (Silver,1 9 8 4 : 4 5 - 4 6 ) .

After a systemic innovation, the costs related to appropriation issuesa re the first to decrease. The knowledge-transmission costs that ariseafter the innovation also decrease and the greater the success of the inno-vation (which eliminates the market agents’ reluctance to acquire the newre s o u rces), the quicker this will take place. However, during this periodof scepticism, the innovator has generated re s o u rces which other agentsnot, precisely because of their initial resistance, so new knowledge-trans-mission costs appear. As agents learn these re s o u rces, transmission costsa re reduce and vertical integration once again decreases (Silver, 1984:4 7 - 4 8 ) .

This model has the great advantage of integrating previous theorieswhilst also incorporating the existence of innovations in the industry as akey factor in understanding vertical integration. Unfortunately, there arefew studies which analyse vertical integration from this perspective(Afuah, 2000), with the exception of the work by Langlois himself (1989)andf past reviews of Silver in different countries (1984).

(4) When innovations are

autonomous (i.e. they

affect only one phase of

the production process),

vertical integration is far

from an efficient form of

organisation, instead it

complicates the

introduction of this kind

of innovation into the

company because less

information is available

and there is no market

competition to force

firms to adopt it

(Robertson & Langlois,

1995).

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6. Conclusions and future line of research

This study broadens the traditional analysis of vertical integration, linkedwith market imperfections due to the existence of market power in thevalue chain or problems of opportunism, with more recent approaches. Inaddition to these motives, associated with the industrial economy andtransaction cost theory respectively, it incorporates an approach based onthe internal characteristics of the company (the resource-based view), aswell as a longitudinal view which analyses the evolution of vertical inte-gration over time. All these approaches and theories have been analysed inorder to identify the main hypotheses associated with vertical integration,the initial assumptions upon which they are based and the empirical evi-dence that exists.

This review serves to highlight the complexity of vertical integrationdecisions, since many factors must be evaluated at the same time. Firstly,the structure of the industry must be analysed since differences in powerbetween phases allow vertically integrated companies to avoid high mar-ket prices imposed by suppliers, eliminate rivals by means of different stra-tegies and lift the industry’s entry barriers. Secondly, it is necessary tounderstand the characteristics of the transactions that take place betweenproduction process phases (uncertainty, specific assets, measurement pro-blems), in order to assess the efficiency of internal organisation withregards the market relationship. Thirdly, the company’s internal capabili-ties, knowledge and other resources must be evaluated in order to applythem to different phases in the production process, thereby making themost of inter-phase synergies. Lastly, it is essential to consider the degreeof maturity and the innovations that arise in the industry in which thecompany implements its strategy, in order to assess the relative importan-ce of each of the above reasons for vertical integration.

This review of existing studies also identifies possible limitations andissues that have not been dealt with, suggesting various lines of researchalong which the analysis of vertical integration could advance. In thissense, it would be extremely useful if the factors identified herein to

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explain vertical integration decisions were applied to the consequencesthat said factors have upon business profitability. Most approaches andtheories assume that vertical integration decisions seek to increase thevalue of the company, either by reducing production costs or by increasingincomes. However, there are in fact few studies which empirically analysethe consequences for business success, with this relationship rarely beingconditioned by the existence of factors which supposedly increase saidprofitability (Harrigan, 1986; D’Aveni & Ravenscraft, 1994; Poppo &Zenger, 1998; Camisón & Guía, 1999; Lieblein et al., 2002).

It would also be interesting to study in greater detail the relationshipsthat exist among the different explanatory factors, rather than analysingeach one separately, as is the case in most studies. The well-known studycarried out by Walker & Weber (1984) in the automobile industry, whichincorporates reasons based on transaction costs together with companycapabilities by means of structural equations, is almost an exceptionamong vertical integration studies. One such relationship analysis couldinvolve an evaluation of whether uncertainty reduces investment in speci-fic assets, in order to avoid problems of opportunism which oblige thecompany to create interdependencies and become less flexible (Mahoney,1992; Shelanski & Klein, 1995). Similarly, it would be interesting to verifywhether very similar phases increase the level of specific assets, reduceinternal transaction costs (Madhok, 2002) and lower entry barriers in oneof the phases (Bain, 1967).

Further extensions of vertical integration studies could be based onlongitudinal analyses which deal with the evolution of vertical integrationwith the industry. It would be very interesting to compare the explanatoryfactors of emerging industries with those of mature industries in order toverify whether the explanatory power of specific assets does indeed lessenover time, whilst the similarity between phases increases. However, giventhe difficulty of obtaining temporal data, it would also be useful to com-pare several industries at different stages of maturity comparing theirdegree of vertical integration and the relative importance of each factor

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identified herein. In particular, an analysis could be made of the role pla-yed by technological changes and innovations in the industry, as the maindetermining factor in vertical integration, following the Robertson &Langlois model.

Lastly, vertical integration studies would be enriched by an analysis oftheir consequences for the company’s organisational design, as some aut-hors have been done (Hoskisson, 1987; Argyres, 1995; Poppo, 1995;Fuente & García, 1999). Most of the existing works in this area considervertical integration as just another form of diversification, without takinginto account the peculiarities of the strategy, in which the different divi-sions have a supplier-client relationship.

In short, an analysis of the reasons that induce companies to verticallyintegrate, incorporating various approaches, is of great use to both deci-sion-makers and researchers. Managers who must decide whether or notto extend the vertical limits of their company should be aware of the dif-ferent factors identified herein. Thus, vertical integration should be carriedout when the following conditions arise: one of the production processphases is highly concentrated, the efficiency of the production processcould be improved by investing in specific assets or sharing resources andcapabilities between them, there exists a great interest in guaranteeing pro-duct quality and firms want to introduce innovations into the productionprocess. For researchers, the analysis of previous studies identifies newlines of work as well as finds better verification methods to be found,whilst also increasing upon the extensive existing literature.

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