Organizations and Markets

Vertical (Dis)integration and Technological Change

18 May 2012 at 2:40 pm Dick Langlois 2 comments

| Dick Langlois |

One of my longest-running interests has been the relationship between economic change, including technological change, and the boundaries of the firm. In broad strokes, my story is this: when markets are thin and market-supporting institutions weak, technological change, especially systemic change, leads to increased vertical integration, since in such an environment centralized ownership and control may reduce “dynamic” transaction costs; but when markets are thick and market-supporting institutions well developed, technological change leads to vertical disintegration, since in that environment the benefits of specialization and the division of labor outweigh the (now relatively smaller) transaction costs of contracting. This latter scenario is what I called the Vanishing Hand. I recently ran across a new working paper by Ann Bartel, Saul Lach, and Nachum Sicherman, called “Technological Change and the Make-or-Buy Decision,” that supports the Vanishing Hand idea empirically. Here is the abstract.

A central decision faced by firms is whether to make intermediate components internally or to buy them from specialized producers. We argue that firms producing products for which rapid technological change is characteristic will benefit from outsourcing to avoid the risk of not recouping their sunk cost investments when new production technologies appear. This risk is exacerbated when firms produce for low volume internal use, and is mitigated for those firms which sell to larger markets. Hence, products characterized by higher rates of technological change will be more likely to be produced by mass specialized firms to which other firms outsource production. Using a 1990-2002 panel dataset on Spanish firms and an exogenous proxy for technological change, we provide causal evidence that technological change increases the likelihood of outsourcing.

The Spanish dataset is based on questionnaires about outsourcing activities in various mechanical industries. The exogenous proxy is number of patents granted in the U. S. in each industry. So, basically, Spanish firms in industries in which there are a lot of American patents tend to outsource more ceteris paribus than Spanish firms in industries with fewer American patents. Although I always like empirical evidence that supports my own arguments, I also like to play the devil’s advocate. The incomplete-contracts literature (which for me is Coase and Knight as much as Hart and Moore) reminds us that it is harder to write contracts when knowledge is tacit and inchoate. Could it thus be that number of patents is a proxy for the importance of explicit versus tacit knowledge in the industry, and it is the prevalence of the explicit, rather than technological change per se, that makes contracting less costly? My money is still on the Vanishing Hand story.

Entry filed under: - Langlois -, Innovation, Theory of the Firm.