A Dynamic Analysis of the Vertical Integration Strategy.

Abstract

A strategic issue faced by the firm is the extent to which it should vertically integrate to manufacture the inputs for its products internally. Most theories of vertical integration approach the subject from a static perspective. In this dissertation, we have attempted a theoretical and empirical analysis of the vertical integration strategy of the firm, from a dynamic perspective. Our arguments for a dynamic analysis rest on two premises: (a) strategy, by definition, relates to the future and future is almost always different from the present and (b) strategic decisions imply resource commitments and few resource commitments, if any, can be made or revoked without incurring some costs. A far-sighted firm, therefore, will base its vertical integration decision, not only on the current market and technological conditions but also on the anticipated changes in these conditions. In the theoretical part of the dissertation, we have developed three dynamic models, based on the transaction cost approach, to analyse the effects of changes in the market and technological conditions on the vertical integration strategy. With the firm facing non-trivial adjustment costs, the optimal strategies of integration are derived, using mathematical optimal control theory. The results reveal that the long-run sustainable configuration of the industry, the rate of technology diffusion and the rate of innovation are crucial to the choice of the firm's vertical integration strategy. In the remaining part of the dissertation, we have sought to examine the empirical implications of our theory, by estimating somewhat simplified versions of our theoretical models. Both inter-temporal and cross-sectional analysis were performed using published data. The results seem to establish the three important implications of our theory: (1) the dynamics of changes in the market and technological conditions are important in explaining the momentary differences in the levels of integration across industries (2) the desirable level of integration in any industry depends on the potential or long-run profitability of the industry (3) the desirable level of integration is further moderated by the frequency of technological changes in the industry. The dissertation is concluded with a discussion on the possible theoretical and empirical extensions.