| The two leading theories of vertical integration are the"Transaction Cost Economics"(TCE) approach of Williamson and the"Property Right Theory"(PRT) approach of Grossman and Hart. Both approaches emphasize the importance of incomplete contracts and ex post opportunistic behavior (hold up) on ex ante relationship-specific investments. The TCE approach views vertical integration as a way of circumventing the potential holdup problems, and thus predicts that vertical integration should be more common when there is greater specificity, increasing the costs of holdup. The PRT,approach, on the other hand, focuses on the role of ownership of assets as a way of allocating residual rights of control, and emphasizes both the costs and the benefits of vertical integration in terms of ex ante investment incentives.This paper investigates the determinants of vertical integration with a simple model, which is an extension of GH model. We develop a simple methodology to study the forces emphasized by the PRT approach. To illustrate the central insight of this paper, we firstly consider a relationship between a supplier (upstream firm) and a (downstream firm) producer. Also suppose that only two organizational forms are possible: ( vertical integration, where the downstream producer buys up the upstream supplier and has residual rights of control, or vice versa) and non-integration (outsourcing),where the producer and supplier are separate firms. Second, we shift the focus from relationship-specific investments to technology intensity and presume that parties making investments of any kind, especially in technology, are subject to holdup, and this will lead to the type of problems highlighted by the TCE and PRT approaches. Third, we look at the relationship between pairs of supplying and producing industries, and focus on the prediction that vertical integration should affect the investment incentives of suppliers and producers in opposite directions. |
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