Williamson (1971) - The Vertical Integration Of Production

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Williamson, Oliver E. (1971), "The Vertical Integration of Production: Market Failure Considerations," American Economic Review, 61:112-23. pdf

 title={The vertical integration of production: market failure considerations},
 author={Williamson, O.E.},
 journal={The American Economic Review},


The study of vertical integration has presented difficulties at both theoretical and policy levels of analysis. That vertical integration has never enjoyed a secure place in value theory is attributable to the fact that, under conventional assumptions, it is an anomaly: if the costs of operating competitive markets are zero, "as is usually assumed in our theoretical analysis" (Arrow, 1969, p. 48), why integrate?


The context of the paper is as follows:

  • Firms have a coordinating advantage over markets
    • Markets have "Transactional Failure"
  • Transaction costs are important only where adaptation is needed.
    • Adaptation is making a relational specific investment
  • The focus on the paper is on incentives (opportunistic behaviour is following one's incentives, rationally) and control in the firm vs in the market.
  • The paper considers only when firms are better, not what makes them worse
  • The properties of governance are: incentives, control, and "inherent structural advantages" (though it isn't clear what the last term means).
    • Control is fiat, which is more efficient than haggling or litigation.
  • A Firm [math]\equiv[/math] "Long term sequential contracts with a fixed arbitrator"

The Theory

The Methodology

The methodology is to apply the Discriminating Alignment Hypothesis.

That is to find what causes problems and then argue how a specific organizational form solves (i.e. has structural advantages).

Ingredient I

Suppose there are a few suppliers for a component that fits into a larger product

Argument I: Bilateral monopoly is not itself a big problem (without double marginalization):

  • There will be bargaining over the surplus - and haggling is costly, which reduces resources (c.f. Coase's theorem and Tullock - Rent dissapation in a contest), at least in the presence of transaction costs.
  • If there is haggling then vertical integration (VI) solves the problem
  • So do spot contracts (either over the contract or other the integration)
    • Therefore VI is as good as a contract (and is a contract!).

Ingredient II

Suppose there are incomplete contracts, but that otherwise we are in a world of Arrow-Debreu securities.

There are three potential solutions:

  1. A long term contract
  2. A sequence of short term contracts
  3. Vertical Integration

For long term contracts to work they need to be Arrow-Debreu contigent contracts.

  • Writing a contract for every state of the world is costly - assume prohibitively, as otherwise there is no need for the contract to be incomplete

There must be adaption on the equilibrium path, which implies the possibility of strategic (opportunistic) behaviour.

Can short term contracts solve this problem?

  • Not if there are relational specific investments (c.f. Klien, Crawford and Alchian, or Grossman and Hart)
  • Not is there are ex-post relational specific advantages (c.f. Masten and Synder)

The main tradeoff is between: Optimal investment and Optimal sequential adaptation. These are at odds. VI solves this tradeoff!