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Vertical Integration: Make, or buy?
What are the issues?
Technological
Strategic
Contractual
Organizational
In a dynamic context
Technological
The ability to partition the work may be critical (I can’t “buy” if I can’t split the work off)
But task boundaries, degree of modularity etc may be endogenous –a product of the history of competition and of each firm’s strategic choices, as well as “given by nature”
Strategic
Avoid double marginalization
Control capacity
Generate complements
Control the evolution of interfaces
Contractual
If lawyers were free and contracts were
perfect…
Specialized assets create the incentive
for “hold up”
Uncertainty
Complexity
BUT:
Organizational
What happens to “effort” – to creativity, to entrepreneurial drive, to initiative – once we integrate?
Contracts , Organizations , and the Integration Decision
Independent contractor
Supplier
Asset
User
The supplier has “residual control rights”
Integrated firm
Supplier
Asset
User
The user has “residual control rights”
Hold up by independent contractors
Supplier
Asset
User
Result: Unwillingness to make “specific investments”
In a supplier
Threat: “Now that you’ve made
that investment in working with me --let’s renegotiate...”
Hold up within an integrated firm
Supplier
Asset
User
Result: Employees reluctant to invest in employer
specific assets
Threat: “We’ll pay you
what you can get elsewhere”
One – Shot Supply Relationships Independent contractor
Supplier
Asset
User
(Value = Q)
“Effort”
Intermediate good
User
(Value = P)
What do the supplier’s incentives look like?
What will the supplier try to do?
One – Shot Supply Relationships Independent contractor
What will happen if:
One – Shot Supply Relationships: Integrated Firm
Supplier
Asset
User
“Effort”
Intermediate good
User
(Value = P)
What do the employee’s incentives look like?
What will the employee try to do?
Make, Buy or Cooperate?
Supplier
Asset
User
(Value = Q)
“Effort”
Intermediate good
User
(Value = P)
Can relational contracts Fix this problem?
Make, buy or cooperate: Using a repeated game
$$$
Time
“Cheat” – fail to pay Q, pay P instead
Honor agreement: Pay Q
Punishment
What will make cooperation feasible?
Low incentives to cheat
“A reputation to uphold”
High incentives to cooperate
The expectation of an enduring relationship
The belief that the other guy understands “the nature of the game”
