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Technical Change, Competition and Vertical Integration

This research analyzes the long-term profit maximization strategies of firms in relation to technical changes and competition. It investigates why integrated firms find certain investments more attractive than independent suppliers. By examining transaction cost economics and standard economic theories, the study highlights how uncertainty, particularly concerning technological obsolescence, affects vertical integration. Empirical tests across 93 industries reveal that increased technical change negatively impacts vertical integration, especially in highly competitive environments, shaping strategic analysis and flexibility.

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Technical Change, Competition and Vertical Integration

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  1. Technical Change, Competition and Vertical Integration SrinivasanBalakrishnan and BirgerWernerfelt Strategic Management Journal, 1986 BADM545, Fall 3012; Prepared by: Hyunsun Kim

  2. Introduction • Strategic perspectives • Purpose: long-term profit maximization • Premises • Future-oriented • Commitment of resources, costly to revoke • Emphasis: implications of changes in technological conditions • Research question: • Why certain investments in the long run would be more attractive to integrated firms than to independent suppliers?

  3. Introduction • Previous literatures • Transaction cost economics: higher profits in the value-added chain -> greater performance for vertically integrated firms • Standard economics: specialized assets (skills) -> greater profits • Predictions regarding uncertainty • Uncertainty, in general, will lead to more vertical integration (Williamson, 1975) • Greater numbers of contingencies: greater costs for contracting • However, a particular uncertainty, the possibility of technological obsolescence, reverses the relationship • Single contingency, decreasing value of the investment

  4. A Simple Model • the optimal level of integration in an industry • increases with: transactional economies • decreases with: bureaucratic diseconomies, competition and technological instabilities • Optimal level of integration: v* • The firm’s greater market share (s) -> high v* • Higher technological instability (1/T) -> low v* • Industry profitability (r,p) -> high v* • Rewarding alternative investment (i)-> low v* • Bureaucratic costs(b) -> low v*

  5. Empirical Test • Unit of analysis: industry • Greater variances for market share (s) and technological instability (1/T) • Measures • Vertical integration • Vertical integration index (VI): the proportion of economic activities carried out within the firm (=value added/sales ratio) • Market share for a representative firm (s) • Minimum economic scale (MES): the average size of the largest firms in the industry which account for 50 percent of the total value of the industry shipment • The mean life of the process technology (T) • Average age (AVAGE) of plant and equipment in use • Data • 93 industries, FTC Annual Line of Business Reports, 1974-76

  6. Empirical Test • Estimation of cross-sectional model • Estimation of pooled model (1974, 75, 76)

  7. Conclusion • Results • The frequency of technical change negatively affects vertical integration, when competition is high • The optimal level of integration depends negatively on the degree of competition in the industry • Implications • Transaction cost economics for strategic analysis/strategic flexibility

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