Vertical Integration

• Author: Paul L. Joskow
• DOI: 10.1177/0003603X1205700303
• Published date: 01 September 2012
• Date: 01 September 2012
• Subject Matter: Article

Vertical integration

BYPAUL L. JOSKOW*

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.

THE ANTITRUST BULLETIN:Vol. 55, No. 3/Fall 2010 :545

* President, Alfred P. Sloan Foundation, New York, NY, and Elizabeth &

James Killian Professor of Economics and Management, Massachusetts Insti-

tute of Technology.

AUTHOR’S NOTE: Portions of this essay draw on material in my papers: Asset Specificity

and Vertical Integration, in THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND

LAW 107 (Peter Neuman ed., 1998); Vertical Integration, in HANDBOOK OF NEW

INSTITUTIONAL ECONOMICS 319 (C. Menard & M. Shirley eds., 2005); and Vertical

Integration, in 1 ISSUES IN ANTITRUST LAW AND POLICY 273 (ABA Section of

Antitrust Law 2008).

© 2010 by Federal Legal Publications, Inc.

I. INTRODUCTION

A great deal of Oliver Williamson’s research has focused on

understanding the factors that lead firms to choose internal organiza-

tion (vertical and horizontal integration) instead of market transac-

tions—that is, his work has focused on the factors that determine the

boundaries between firms and markets and the internal organization

of firms—as well as on the factors that lead firms to eschew simple

anonymous spot market transactions in favor of more complex verti-

cal contractual arrangements—what I will refer to in this article as

“nonstandard contractual arrangements.” Williamson’s work and the

work of those that have built on it both theoretically and empirically

have led to fundamental changes in the way we think about vertical

integration and nonstandard contractual arrangements between firms

at different levels of the production and distribution chain. While we

can point to Coase as raising the fundamental questions regarding the

boundaries between firms and markets and the potential role of

largely undefined transaction costs,1it is Williamson who reignited

interest in this perspective, significantly moved the theory forward,

and stimulated an enormous amount of empirical research on these

issues. An important conceptual lesson from Williamson’s work is

that it is not particularly useful to posit a sharp dichotomy between

internal organization, such as vertical integration, and market trans-

actions. Rather, the appropriate conceptual framework recognizes a

continuum of governance arrangements between spot market trans-

actions and internal organization, including combinations of both,

such as dual sourcing.

Of course, Williamson was not the first economist to address

these issues. Understanding the factors that determine which types of

transactions are mediated through markets and which within firms

through vertical and horizontal integration has been an important

subject of theoretical and empirical research in microeconomics for

many years. Moreover, vertical integration and related nonstandard

contractual arrangements (sometimes referred to as “vertical

restraints” in the antitrust policy arena) have historically attracted

considerable attention under U.S. antitrust laws. Surprisingly, how-

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1Ronald Coase, The Nature of the Firm, 4 ECONOMICA 386 (1937).

ever, most intermediate microeconomics textbooks pay little if any

attention to the causes and consequences of vertical integration

between suppliers of intermediate goods and services (“upstream”)

and the purchasers of those goods and services (“downstream”), and

the typical undergraduate who majors in economics (and perhaps

goes on to law school and later in life becomes a judge) may learn

nothing about vertical integration, the transaction and organizational

factors that affect the boundaries between firms and markets, and

contractual alternatives to spot market transactions.

This article reviews the theoretical and empirical work in micro-

economics that examines the causes and consequences of vertical

integration. I want to emphasize at the outset that there is not and

will never be one unified theory of vertical integration. Moreover,

while some of the literature on vertical integration continues to focus

on a sharp dichotomy between the decision to make internally or buy

through the market, work by Williamson and others working in the

transaction cost economics tradition that he pioneered, teaches us that

in reality these two governance arrangements are polar cases. A com-

prehensive analysis of the underlying causes and consequences of

vertical integration should not only examine the determinants of the

boundaries between firms and markets but also the origins of various

nonstandard contractual arrangements or “hybrid forms” that lie

between simple anonymous spot market transactions and internal

organization. These hybrid forms include various types of long-term

contracts, franchise contracts, nonlinear pricing arrangements, resale

price maintenance (RPM) agreements, requirements contracts, joint

ventures, dual sourcing (partial vertical integration) and others.

Depending on the circumstances, these alternative contractual

arrangements may be perfect or imperfect substitutes for vertical inte-

gration for dealing with problems that may arise as a result of relying

only on simple repeated spot market relationships between upstream

and downstream firms.

Virtually all theories of vertical integration turn in one way or

another on the presence of market imperfections—deviations from

the long list of explicit and implicit assumptions that are associated

with textbook models of perfect competition and anonymous spot

market transactions that are mediated through hypothetical perfectly

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