Vertical Integration

Abstract

Oliver Williamson's work on transaction cost economics, and more generally on the factors that determine the boundaries between firms and markets, has provided key insights that have significantly expanded our understanding of the attributes of transactions and organizations that lead to vertical integration and vertical contractual relationships more broadly. Transaction cost—based theories of vertical integration focus on the implications of incomplete contracts, asset specificity, information imperfections, incentives for opportunistic behavior, and the costs and benefits of internal organization. These theories focus on efforts by firms to mitigate transaction costs and various contractual hazards that may arise with anonymous spot market transactions by choosing among alternative organizational and contractual governance arrangements that can reduce these costs. There is substantial empirical support for these theories. Property rights—based theories are sometimes interpreted as formalizing some of Williamson's work. However, little empirical work has focused on property rights—based theories per se. Principal-agent theories of vertical integration that are distinguished from other organizational theories primarily by assumed differences in risk aversion between principals and agents and associated moral hazard problems have also been advanced. They add little to the other theories and have limited independent empirical support.