1. Vertical Integration: Make, or buy?

2. What are the issues? Technological Strategic Contractual Organizational In a dynamic context

3. Technological The ability to partition the work may be critical (I can’t “buy” if I can’t split the work off) But task boundaries, degree of modularity etc may be endogenous –a product of the history of competition and of each firm’s strategic choices, as well as “given by nature”

4. Strategic Avoid double marginalization Control capacity Generate complements Control the evolution of interfaces

5. Contractual If lawyers were free and contracts were perfect… Specialized assets create the incentive for “hold up” Uncertainty Complexity BUT:

6. Organizational What happens to “effort” – to creativity, to entrepreneurial drive, to initiative – once we integrate?

7. Contracts, Organizations, and the Integration Decision

8. Independent contractor Supplier Asset User The supplier has “residual control rights”

9. Integrated firm Supplier Asset User The user has “residual control rights”

10. Hold up by independent contractors Supplier Asset User Result: Unwillingness to make “specific investments” In a supplier Threat: “Now that you’ve made that investment in working with me -- let’s renegotiate...”

11. Hold up within an integrated firm Supplier Asset User Result: Employees reluctant to invest in employer specific assets Threat: “We’ll pay you what you can get elsewhere”

12. One – Shot Supply Relationships Independent contractor Supplier Asset User (Value = Q) “Effort” Intermediate good User (Value = P) What do the supplier’s incentives look like? What will the supplier try to do?

13. One – Shot Supply Relationships Independent contractor What will happen if:

14. One – Shot Supply Relationships: Integrated Firm Supplier Asset User “Effort” Intermediate good User (Value = P) What do the employee’s incentives look like? What will the employee try to do?

15. Make, Buy or Cooperate? Supplier Asset User (Value = Q) “Effort” Intermediate good User (Value = P) Can relational contracts Fix this problem?

16. Make, buy or cooperate: Using a repeated game $$$ Time “Cheat” – fail to pay Q, pay P instead Honor agreement: Pay Q Punishment

17. What will make cooperation feasible? Low incentives to cheat  “A reputation to uphold” High incentives to cooperate The expectation of an enduring relationship The belief that the other guy understands “the nature of the game”