Williamsons model

Williamson (1985) developed a model to determine the optimal level of vertical integration and the size of the firm. He distinguishes between:

■ Technical efficiency, which indicates whether the firm is using least cost production techniques.

■ And agency efficiency, which indicates the extent to which the firm minimizes coordination, agency and transaction costs.

He argues that the optimal vertically integrated firm minimizes the sum of production and transaction costs compared with the market alternative. The model assumes that the quantity of the good being exchanged is fixed. In Figure 16.3 the vertical axis measures differences between costs arising from internal organization and costs arising from market transactions. Positive values indicate that costs from internal organization exceed costs from market transactions. The horizontal axis measures asset specificity where higher values (or positions to the right) indicate a greater degree of asset specificity. Asset specificity is the extent to which assets can only be used to meet the requirements of one customer. If the asset has no alternative use other than its present use, then it has no value in any alternative use.

The curve AC measures the differences in technical efficiency: that is, the minimum cost of production under vertical integration (C;) minus the minimum cost of production under market exchange (Cm). AC, or (C; — Cm), is positive for any level of asset specificity because outside suppliers can aggregate demands from other buyers and, thus, take advantage of economies of scale and scope to achieve lower production costs than firms that produce the inputs themselves. The cost difference declines with increasing asset specificity because greater asset specificity implies more specialized uses for the input and, thus, fewer outlets for the outside supplier. As a result, with

Figure 16.3 Vertical integration and asset specificity

Source: Reproduced from Williamson (1985, p. 93) by permission of The Free Press

Figure 16.3 Vertical integration and asset specificity

Source: Reproduced from Williamson (1985, p. 93) by permission of The Free Press greater asset specificity the scale and scope-based advantages of outside suppliers are likely to be weaker.

The curve AG reflects differences in agency efficiency. It measures differences in transaction costs when the item is produced internally (G;) and when it is purchased from an outside supplier (Gm) in an arm's length transaction. When the item is purchased from an outside supplier, these costs comprise the direct costs of negotiating the transaction, the costs of writing and enforcing contracts, the costs associated with hold-ups and with underinvestment in relationship-specific assets. AG reflects the differences in agency efficiency between the two modes of organizing transactions. The curve is positive for low levels of asset specificity and negative for high levels of asset specificity. When asset specificity is low, hold-up is not a significant problem. In the absence of asset specificity, market exchange is more likely to be agency-efficient than vertical integration.

The curve AC + AG is the vertical summation of AG and AC. It represents production and exchange costs under vertical integration minus production and exchange costs under market exchange. Therefore:

■ If AC + AG is positive, then arm's length market exchange is preferred to vertical integration. The firm will be located between O and K*.

■ If AC + AG is negative, then vertical integration is preferred because the exchange costs of using the market are more than offset by the production costs savings. The firm will be located to the right of point K*.

Thus:

■ Market exchange is preferred when asset specificity is low (i.e., K is less than K*).

■ Vertical integration is preferred when asset specificity is high (i.e., K is greater than K*).

Vertical integration becomes increasingly attractive as economies of scale become more pronounced. The position of the AC curve reflects the ability of the independent producer to achieve scale economies in production by selling to other firms. Weaker economies of scale would shift AC to the right, reducing the range in which vertical integration dominates market transactions. Stronger economies of scale associated with large firms would shift AC to the left, increasing the relevant range that favours vertical integration.

The following conclusions can be drawn about the drivers of vertical integration:

1 If scale and scope economies are significant, then the firm gains less from integration the greater the ability of the external supplier to take advantage.

2 The larger the product market the more a firm will gain from vertical integration. The more the firm produces and the faster its growth the more likely it will be to vertically integrate.

3 The firm with multiple product lines and few inputs may benefit from vertical integration.

4 Where asset specificity is important the firm gains more from vertical integration. If asset specificity is significant enough, vertical integration will be more profitable than market transactions, even when production of the input is characterized by strong scale economies or when the firm's product market scale is small.

Continue reading here: Case Study 163 Fisher Body and General Motors

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