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The emergence of the “New Institutional Economics” led to a revival of the efficiency explanations of institutions. The theory of transaction costs, in particular, is said to provide a “scientific” explanation of the existence, size and hence degree of vertical integration (VI) of firms. Furthermore, as we shall see, this theory also seemed to imply that the level of VI is the optimal one with obvious implications for the appropriate government policy towards them.

TC have been described by Arrow as the costs of running the economic system but besides that no clear definition has been provided. TC can be classified as “ex ante” which include search and information costs and the bargaining, deciding and drafting of a contract and as “ex post” which refer to the execution, policing and enforcement costs of this contract. TC have been said to arise for a variety of reasons but uncertainty and imperfect information are probably the most important factors to the extent that some (such as Dalhman) have even argued that in fact all TC are due to uncertainty. In any case, as Williamson pointed out, imperfect information is a problem mainly because of two behavioural traits: bounded rationality and opportunism.

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Bounded rationality, a concept of H. Simon, has been defined as a “biological limitation of the ability to receive, store and retrieve information”. It can cause TC because it means agents will have to incur extra costs to process and understand information while if they fail to take into account all contingencies so that further negotiation will be needed after the unexpected event. Opportunism which refers to “self-interest with guile” means that agents may exploit asymmetric information they possess leading to (fears of) adverse selection ex ante and moral hazard ex post.

The complexity of the transaction and its frequency are also important determinants of TC. Williamson suggested that “Asset specificity” (AS) is another important determinant of TC since it tends to make contracts more complex. AS refers to the investment of agents in assets which are of value only in specific transactions and it can be human, technological or geographical. AS, therefore, leads to the “fundamental transformation”: resources which where previously demanded by many agents are now locked to a limited number of them providing scope for opportunistic behaviour thus requiring long-term contracts and protracted bargaining which raise TC.

New Institutional Economics explain the presence of firms by the attempt of agents to minimise TC. Following Coase (1937), markets and firms are seen as alternative ways of organising exchanges, the former involving allocation through the price mechanism while the later mainly relies on the use of authority. Williamson (1981) extended this analysis by recognising that agents have various alternative “terms of governance” of how transactions are organised with firms as just one of them (the “unified governance structure”). Similarly it has been pointed out that this distinction between price mechanism and authority is not really accurate and indeed Williamson’s analysis is much concerned over the internal organisation of the firm but this is not really relevant to our analysis.

VI refers to the incorporation of two or more technologically separable stages of production in one firm and it can be distinguished in backward (upstream) and forward (backstream) integration. The TC theory can explain the size of the firms as well as their existence : transactions are internalised within a firm up to the point where the marginal reduction in TC is equal to the increased administrative costs. Hence it can also explain VI which is just a special case of internalisation of transactions. Indeed, the questions of why firms exist and why do we have VI are very closely related since all firms are in fact VI if one takes sufficiently narrow definition of production stages. The TC explanation of VI has been described by some as the “market failure” approach.

There are many reasons for which TC may be lower if some transactions are internalised in a firm. Coase mentions the costs of getting information on prices, the costs of negotiating and drafting a contract and the additional complications when long-term contracts are needed. Firms are able to lower TC because “one contract replaces many” as the firm managers are given discretion to act within certain limits without the need for new contracts to be made.

Government tax policies may also encourage integration if, for example, it taxes market transactions but not internal ones. For Williamson the major reason is asset specificity which as we saw increases the costs of drafting a contract in a market framework. Integration may reduce TC associated with AS as the common interests moderate the disputes and as management can exercise its authority to put an end to protracted bargaining or to demand information from its employees.

Imperfect information is also very important and can affect firm size in many ways. Alchian and Demsetz pointed out to the difficulty in assessing individual contribution where we have team production but this is unlikely to be a factor in VI. Difficulties in checking imput quality (i.e. an externality for the upstream producers arising from asymmetric information) are likely to be more relevant for VI. Arrow argues that downstream producers have only limited information on imput prices so they find it difficult to make efficient decisions on imput proportions in their own production. This means that downstream producers have an incentive to acquire upstream firms but it is not clear why downstream firms are less able to predict the conditions of demand for imputs.

Carlton alternatively argues that uncertain demand for the final product, combined with rigidities in the upsteam industries, makes the latter to restrict their output so as to avoid having unused stocks, leading to imput prices above MC. Backward integration by downstream firms may thus occur to have the imputs at cost. To the extent that this simply involves a transfer of profits from the upstream to the downstream firm it is not a valid argument for VI unless they have better information of final demand and can make the upstream firm produce closer to the efficient level.

Chandler proposed that VI may occur because close co-ordination between imput-producers and distributors are necessary in order to maintain throughput. This will be particularly important for capital intensive industries with high fixed costs. Indeed Chandler has argued that this can explain the move towards VI of the big US and German manufacturing firms of the late 19th century. Another possibility is that VI is required to support innovation.

This may be due to the lower finance costs of large firms (which could perhaps be incorporated in TC analysis to the extent that this is because banks are able to spread more the TC when dealing with big firms or because small firms involve more search costs for the bank to check if they are trustworthy or not). Furthermore, distributors and imputs producers may lack information about new products and persuading them may be expensive (eg. market surveys etc.).

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