Wednesday, March 14, 2012

Analyzing Vertical Integration using Transaction Cost Theory

In the last blog we looked how Hierarchy mitigates the risks of transaction specific investment. In this blow we begin the discussion on the application of transaction cost theory and briefly understand one of the applications.

Transaction cost theory could be used to understand numerous the following types of organizations better

  • Vertical Integration
  • Multi-divisional form or organization
  • Markets, Bureaucracies and Clans
  • The Multinational Enterprise
  • Hybrid form of organization

Now we look at the first of these - Vertical Integration. 

Vertical Integration is a process by which companies expand their business in the same production path, along the supply chain. Reliance’s expansion from polyester to petroleum refining is an example of this vertical integration. It could be forward or backward. We shall discuss this and more elsewhere when we talk about strategy.

Vertical Integration is one of the most researched applications of TCT. TCT scholars typically use transaction as their level of analysis instead of viewing it as an aggregate measure of value adds for the entire firm. Simply put it deals with the "make or buy" decisions.

Research has found that a high transaction specific investment would yield the decision to internalize the operation; independent of the type of transaction (which could be capital, human resource, specific skills, and location. Uncertainty is found to be less consistent in when compared to the transaction specific investment in the decision making of firms.

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