Toward an integrated theory of the firm: The interplay between internal organization and vertical integration

• Author: Jorge Tarziján,Francisco Brahm
• DOI: http://doi.org/10.1002/smj.2446
• Date: 01 December 2016
• Published date: 01 December 2016

Strategic Management Journal

Strat. Mgmt. J.,37: 2481–2502 (2016)

Published online EarlyView 17 November2015 in Wiley Online Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2446

Received 20 May 2014;Final revision received28 August 2015

TOWARD AN INTEGRATED THEORY OF THE FIRM:

THE INTERPLAY BETWEEN INTERNAL

ORGANIZATION AND VERTICAL INTEGRATION

FRANCISCO BRAHM*and JORGE TARZIJÁN

School of Management, Pontificia Universidad Católica de Chile, Santiago, Chile

Research summary: Two centralissues in strategic management are the determination of a rm’s

internal delegation and its vertical boundaries. Despite the importance of these issues, there is

scant analysis concerning their interaction. Using a comprehensive database of the construction

industry, we show that vertical integration positively inuences the centralization decision and

that the main mechanism driving this relationship is an improvement in the hierarchically coor-

dinated adaptation of rm activities when complexity and uncertainty are high. We also observe

that centralization is negatively related to the extent of relational contracts between principals

and agents, and positively related to an exogenous increase in the cost of employee layoffs. Our

results suggest that managers cannot consider rm boundaries and internal organization to be

independent decisions.

Managerial summary: We ask whether a rm’s decision about vertically integrating or out-

sourcing its activities affects the choice of centralizing or delegating its internal decision-making

process. Our statistical analysis shows that rms with more vertical integrationtend to centralize

the decision-making process and that rms that outsource more tend to decentralize more. Why?

Vertical integration enables the use of centralized authority to coordinate activities that interact

intensively. Accordingly, we found that the positive inuence of vertical integration on central-

ization is especially signicant in more complex and uncertain environments, when the need for

coordination is higher. Thus, our results suggest that managers should choose vertical integration

considering its effect on internal decision-making processes, particularly when coordination is

important. Copyright © 2015 John Wiley & Sons, Ltd.

INTRODUCTION

A major body of literature within organiza-

tional economics considers the determination

of rm internal organization. A cornerstone of

this research examines the choice to centralize

decision-making at the top of the organization

or delegate it to lower level managers (Aghion,

Bloom, and Van Reenen, 2014; Argyres and

Keywords: centralization; vertical integration; adaptation;

agency costs; prior interactions

*Correspondence to: Francisco Brahm, Ponticia Universidad

Católica de Chile, School of Management, Vicuña Mackenna

4860, Santiago, Chile. E-mail: fbrahm@uc.cl

Copyright © 2015 John Wiley & Sons, Ltd.

Silverman, 2004). Another major body of literature

in this eld is concerned with the determination of

rm boundaries, that is, the make-or-buy decision

(Coase, 1937; Williamson, 1975, 1985). Despite

the importance of these bodies of literature, there

has been scant analysis of a possible interrela-

tionship between them. This void is noteworthy

because a sound theory of the rm requires an

understanding of how internal organization and

rm boundaries interact.1For example, if delega-

tion and outsourcing were complements, then for

1A third aspect that an integrated theory of the rm should account

for is heterogeneity of rm performance (Mahoney and Qian,

2013). We do not address this issue explicitlyin our article.

2482 F. Brahm and J. Tarziján

a given set of activities, we would observe either

delegation and outsourcing or centralization and

integration. A complementary relationship between

these organizational decisions is consistent with

theoretical arguments regarding the difculty of

integrating and then delegating (Baker, Gibbons,

and Murphy, 2001), but contradicts popular press

advice for empowerment and delegation regardless

of rm boundaries (Foss and Klein, 2014).

Calls to explore the internal organization and rm

boundaries jointly have been issued in the literature

(Acemoglu et al., 2007; Bidwell, 2012; Holmstrom,

1999). Garrouste and Saussier note, “In addition to

the questions regarding the nature and the bound-

aries of the rm, the theory of the rm should

also be able to cope with the question of inter-

nal organization.” (2005: 187). Received theory is

insufcient. The new property rights theory by Hart

and Moore (1990) posits that legal ownership of

assets involves complete centralization of decision

rights, that is, vertical integration and centraliza-

tion are largely inseparable.2In contrast, the trans-

action cost economics (TCE) perspective indicates,

“Substantially the same factors that are ultimately

responsible for market failures also explain failures

of internal organization” (Williamson, 1973: 316),

predicting that centralization and vertical integra-

tion will co-vary with transactional attributes, but

neglecting their direct mutual inuence. A multitask

principal-agent model (Holmstrom and Milgrom,

1994) assumes a pattern of tasks interdependence

that produces a positive relationship among central-

ization of authority, vertical integration, and lack

of incentives. However, assuming a pattern lim-

its the theory’s explanatory depth on the relation-

ships among these three governance instruments.

Makadok and Coff (2009) extend the multitask-

ing agency model to show that by altering the

assumed interdependence between tasks, the model

can account for a variety of organizational forms

combining different levels of centralization, verti-

cal integration, and incentives. However, the model

cannot predict which combinations are more preva-

lent. As Makadok and Coff indicate, “[our theory]

does not imply that every part of the governance

space is populated with viable forms. Indeed, some

parts of the space might be sparsely populated— or

2Attempts to extend the property rights model to include internal

organization have been made: Powell (2015) uses “inuence

costs,” Rajan and Zingales (1998) use “access to assets,” and Hart

and Holsmtrom (2010) use “reference points.”

even empty, when the particular combination of

governance elements is impractical, infeasible, or

unstable” (2009: 300).

There is some empirical evidence that sug-

gests a positive relationship between centralization

(delegation) and vertical integration (outsourcing)

(Alonso, Clifton, and Díaz-Fuentes, 2015; Arora,

Belenzon, and Rios, 2014; Chanson and Quelin,

2013; Hong, Kueng, and Yang, 2015; McElheran,

2014; Weigelt and Miller, 2013; Whittington et al.,

1999). However, this evidence is correlational, and

thus, cannot speak to whether these two deci-

sions co-vary because of transaction character-

istics, as TCE would predict, or whether there

is a specic interdependence between them that

would inform Makadok and Coff (2009)’s question

regarding the feasibility of organizational forms.

The distinction between transaction characteristics

and complementarity of governance instruments

is empirically important. For instance, Novak and

Stern (2009) show that the effect of complementar-

ity in vertical integration decisions is at least as rele-

vant as the impact of the transaction characteristics.

We contribute to this literature by providing a

focused empirical analysis of the impact of verti-

cal integration on centralization. In particular, we

use appropriate instruments to evaluate the causal

impact of vertical integration on centralization. This

approach enables us to evaluate whether vertical

integration correlates with centralization or whether

it exerts a causal inuence. By contrasting the

impact of vertical integration on centralization with

other canonical drivers (drawn from transaction

characteristics), we can evaluate whether the inter-

dependency is economically meaningful compared

to these drivers. Finally, although some generaliz-

ability may be sacriced, our approach permits us

to (1) provide detailed evidence that corroborates

a suggestive pattern found in previous studies, (2)

distinguish the mechanisms that might be driving

the results, and (3) spur theoretical work that is

needed to develop a theory that jointly addresses

rm boundaries and internal organization.

Weproceed by introducing the two main determi-

nants of the centralization decision, namely, adapta-

tion costs and agency costs. To predict the impact

of vertical integration on centralization, we dis-

cuss how vertical integration may affect the adapta-

tion and agency costs of the centralization choice.

Then, we estimate the impact of vertical integra-

tion on centralization. To explore the mechanisms

that may be driving the results, we evaluate whether

Copyright © 2015 John Wiley & Sons, Ltd. Strat. Mgmt. J.,37: 2481–2502 (2016)

DOI: 10.1002/smj