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Do it yourself? Why firms bring activities "in house"

In most developed economies, transactions within firms are roughly equal in value to those that occur in markets. But which sorts of transactions are best organised in firms and which in markets? In a recent survey, Francine Lafontaine and Margaret Slade summarise the latest theories and empirical evidence on the boundaries of the firm.

Where should firms end and markets begin? Managers constantly face choices about whether to do something themselves or buy in the services of another firm to do it for them. For example, car manufacturers must decide whether to produce car bodies or to purchase them from independent suppliers. In addition, firms can sell their products themselves or they can use independent retailers. For example, most fast-food franchisers operate some outlets themselves and franchise others.

Firms that undertake activities at different stages of the production process are "vertically integrated." For managers, whether to pursue "backward integration" by acquiring a supplier (the make-or-buy decision) or "forward integration" by acquiring a retailer (so as to sell directly to customers) are crucial strategic questions.

The extent of vertical integration also raises issues for policy-makers, notably when assessing whether a proposed takeover by one firm of another at a different stage of production is potentially anti-competitive. For example, when a provider of cable TV services purchases a producer of cable TV programmes, competition authorities are concerned that programmes of rival producers will not be shown.

In the past, the economics profession has devoted much more attention to the workings of markets than to the study of firms, and even less attention to the boundaries between the two. Nevertheless, a growing body of research has focused on what types of transactions are best brought within the firm, as well as the consequences of vertical integration for outcomes such as prices, output, investment and profits. For the most part, forward and backward integration have been analysed using different models.

Vertical integration is principally motivated by a desire to increase efficiency rather than to reduce competition

Forward integration into retailing » Forward integration, in which one firm owns another firm that operates closer to the consumer (say, McDonalds operates its own retail outlets), has mainly been analysed using moral-hazard models, in which both parties must be given incentives.

Without integration, a retailer has strong incentives to work hard, since he is an independent businessman. But an independent retailer is not protected from market risk, as he would be if he were a salaried employee. If the retailer is risk-averse, there is therefore a trade-off between providing him with incentives, which markets do well, and insurance, which firms do well.

For example, the operator of a petrol service station can be an employee of the oil company (forward integration) or he can be an independent operator. If the oil company owns the station, it can choose the vertical relationship between the two levels of the vertical chain.

In most cases, the chosen arrangement will depend on the characteristics of the station (for example, does it have a convenience store or repair bays?) and the market (for example, is the location urban or rural?). These characteristics are relevant because they determine the importance of the retailer’s effort as well as the difficulty of monitoring his activities.

The empirical evidence indicates that forward integration is more likely to occur when the value of the manufacturer’s brand is greater; when the retail outlet is larger; when the retailers’ effort is less important; when the firm’s operations are less dispersed geographically; and when the environment is less risky.

With the exception of the effect of risk, all these findings are supportive of a simple moral-hazard model of incentive provision. But the robust and perverse effect of risk casts doubt on the trade-off between incentives to supply effort and insurance that is fundamental to the model.

The drivers of vertical integration vary according to whether it is "forward" into retailing or "backward" into supply

Backward integration into input supply » Backward integration, in which one firm owns another that is further from the consumer (say, a car manufacturer owning a producer of car parts), has mainly been assessed using transaction-cost models, which emphasise the costs of writing contracts.

Here, contracts are modelled as incomplete (they do not specify what will happen in all circumstances) and investments are specific (they have more value inside than outside the relationship). Without integration, this combination of factors can give rise to costly and inefficient re-contracting, opportunistic behaviour and under-investment. Each of these tends to be mitigated inside firms.

For example, a car manufacturer may ask a car parts supplier to produce a part that requires a machine with few alternative uses. Once the investment is made, the manufacturer can offer to pay a lower price for the part than the promised price. After the investment is sunk, the supplier of parts can only accept the lower price or refuse to supply, in which case he will have lost the value of his investment. But as the supplier can anticipate such opportunistic behaviour on the part of the manufacturer, he will not invest in the first place.

The empirical evidence indicates that backward integration is more likely when investments are specific; when the environment is uncertain; and when transactions are complex. These findings support the transaction-cost model (with the caveat that the model predicts that vertical integration is more likely to occur under a combination of these factors, not under each one individually).

Vertical mergers should be assumed to be benign unless there is strong evidence to the contrary

Consequences of vertical integration » The consequences are difficult to predict theoretically and there are many ambiguities. But most empirical studies find that vertical integration is motivated by a desire to increase efficiency rather than to reduce competition.

Furthermore, even when the analysis is limited to natural monopolies or tight oligopolies, the evidence of anti-competitive behaviour is not strong. This suggests that the authorities should assume the burden of proof of consumer harm. In other words, vertical mergers should be assumed to be benign unless there is strong evidence to the contrary.

Publication details

The authors

  • Francine Lafontaine is professor of business economics and public policy at the Ross School of Business at the University of Michigan.
  • Margaret Slade was Leverhulme Professor of Industry and Organization in the University of Warwick’s economics department between 2002 and 2007. She remains a professor in the department.

Further reading

  • Francine Lafontaine and Margaret Slade (forthcoming). "Exclusive Contracts and Vertical Restraints: Empirical Evidence and Public Policy." In The Handbook of Antitrust Economics, edited by Paolo Buccirossi. MIT Press.
  • Francine Lafontaine and Margaret Slade (2001). "Incentive Contracting and the Franchising Decision." In Game Theory and Business Applications, edited by Kalyan Chatterjee and William Samuelson. Kluwer Academic Press.