Vertical integration occupies a central role in organizational economics. Williamson (2005) calls it the “paradigm” problem for explaining the distribution of firms and markets in modern economies. In this chapter, we review research on vertical integration decisions and their consequences, and offer some perspective on the current state of knowledge.
Our discussion bridges two very different literatures. Research in organizational economics generally treats vertical integration as an efficient response to contracting frictions. This approach is often associated with Coase (1937) and Williamson (1971). Research in industrial organization has taken a complementary approach, emphasizing patterns of integration at the market or industry level. Some of this work, following Stigler (1951), draws attention to scale and scope economies as rationales for integration, while other strands emphasize strategic motives and the idea that integration can be a tool for consolidating or extending market power.
Theoretical work in the first tradition argues that certain features of transactions create particular problems for arm’s-length contracting. These can include difficulty anticipating future contingencies, ambiguity in the nature of tasks and decisions to be carried out, the need to use specific assets, or an inability to measure and verify transaction outcomes. In Section 2, we describe some of the “building-block” models that link these types of transactional frictions to problems of holdup, decision making externalities, and incentive distortions, and offer explanations for when and why internal organization might lead to more efficient outcomes.