AB-2010-55-3-03-JOSKOW, Vertical Integration By Paul 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.