1. Technical Change, Competition and Vertical Integration
Srinivasan Balakrishnan and Birger Wernerfelt
Strategic Management Journal
BADM 546, Group #1
Meredith Blumthal
Wooje Cho
Barclay James
Kumar Sarangee
BADM 546

2. Overview Research Question: Vertical Integration
Why would certain investments in the long run be more attractive to integrated firms than to independent suppliers?
Vertical Integration
The combination of technologically distinct production, distribution, selling and/or other economic processes within the confines of a single firm… a decision by the firm to utilize internal or administrative transactions rather than market transaction to accomplish its economic purpose. (Porter)
BADM 546, Spring 2005

3. Theories of Vertical Integration
Economies of Integration
The strategy of integration will be preferred:
Competitive Considerations: when integration introduce entry or mobility barriers to competition resulting in higher revenues to the integrated firm
Production economies: when there are production economies of scope
Transactional economies: when there are transactional economies in integration
Investments in specialized assets and technological change: if the technology is expected to be relatively short-lived, the decision not to integrate is correct
BADM 546, Spring 2005

4. A Simple Model A firm’s integration strategy depends on:
Competitive considerations
Market transaction costs
Bureaucratic diseconomies
Technological instabilities
Model for firm’s profitability and integration
π (v) = vps [1 - m (1 - v) - bv]
v: faction of being selected parts of the value-added chain in the industry
s: market share (p*s: basic level of profitability in the industry
m: fraction of the profits lost in market transactions
b: fraction lost in bureaucratic transactions
BADM 546, Spring 2005

5. A Simple Model Expected Net Present Value of all future profits
Optimal level of integration v*
T: expected time to the innovation
r: discount rate
i: the rate of investment elsewhere except the internal value-added chain
m: fraction of the profits lost in market transactions
b: fraction lost in bureaucratic transactions
BADM 546, Spring 2005

6. A Simple Model Three separate cases: When v* = 0 When v* = 1
The firm would prefer a negative level of participation
Very common case
No firm participates in all industries and can thus be said to have decided against participation in some industries
When v* = 1
The firm would prefer to invest more than the maximum feasible amount in the industry
Very rare case
Ex. Some petrochemical firms
When 0<v*<1
Need to find optimal value of v* (optimal level of vertical integration)
The empirical study of this paper focus on the case
BADM 546, Spring 2005

7. Empirical Test
Purpose: Analyze the effect of technological instability (1/T) and the market share of a representative firm (s)
Analysis level: industrial level
Assumptions
p, b, m, r, and i are similar across industries
The linear relation between equilibrium market share and profitability may be reasonably valid across different industries
Testing Model
vi = β0 + β1 (1/s) + β2 (1/s) (1/T) + ei
BADM 546, Spring 2005

8. Empirical Test Measuring Data
Level of vertical integration (v): a vertical integration index which measures the proportion of economic process carried out within the firm
Market share for a representative firm (s): MES (Minimum economic scale)
Mean life of the process technology (T): average age of plant and equipment in use
Data
93 SIC-4 digit level manufacturing industries which are randomly selected from among the 261 industries included in the FTC Annual Line of Business Reports
BADM 546, Spring 2005

9. Empirical Test Results
The results are consistent with the theoretical expectation
Level of vertical integration decreases as competition goes up
By lowering the entry barriers
Integration levels are lower in industries characterized by frequent technological changes
BADM 546, Spring 2005

10. Conclusions
Especially if the degree of competition is high, integration is affected negatively by the frequency of technological change
The optimal level of integration depends negatively on the degree of competition in the industry
However, vertical integration strategy is a complex and controversial topic, so simple-minded rules of thumb are potentially misleading
BADM 546, Spring 2005