Vertical Boundaries

Topics: Transaction cost, Economics, Contract Pages: 16 (4375 words) Published: December 5, 2010
Chapter 10: Vertical boundaries

Chapter 10: Vertical boundaries
Aim of the chapter
To understand the factors that influence the ways in which transactions on a vertical chain (value chain) should be/are located on the market–organisation continuum.

Learning objectives
On completion of this chapter and the essential reading, you should have a good understanding of the following terms and concepts: • transaction cost economics • strategic calculation.

Essential reading
Buchanan, D. and A. Huczynski Organizational behaviour: an introductory text. (London: Prentice Hall, 2008) Chapter 18. Douma, S. and H. Schreuder Economic approaches to organisations. (London: Prentice Hall, 2008).

Further reading
Besanko, D., D. Dranove and M. Shanley Economics of strategy. (New York: Wiley, 1996). Coase, R.H. ‘The problem of social cost’, Journal of Law and Economics 3 1960, pp.1–44. Grossman, S. and O. Hart ‘The costs and benefits of ownership: a theory of vertical and lateral integration’, Journal of Political Economy 94(4) 1986, pp.691–719. Williamson, O.E. ‘The economics of organization: the transaction cost approach’, American Journal of Sociology 87(3) 1981, pp.548–77.

10.1 Introduction
As noted in Chapter 1, we may regard the basic unit in organisational analysis as an exchange or transaction generated in the division of labour. The division of labour (exogenous/endogenous – Chapter 3) creates value or vertical chains; for example as shown in Figure 10.1(a) running from crude oil extraction to the retailing of petroleum products. We now operate at the level of organisations or firms (recognising that at a greater level of disaggregation the points in the chain are also based on chains of the division of labour) and pose the question as to where their boundaries should be located on the value chain. In fact the picture is usually more complex than the one depicted in Figure 10.1(a). Activities usually depend on inputs at all points down the vertical chain, as depicted in Figure 10.1(b). So organisations or market exchanges could control and coordinate each of these transactions. Furthermore, some of these inputs may be common to the points on the main chain (see Appendix 1.2 in this guide), like accounting services, in which case the picture looks more like Figure 10.1(c). Note the use of di-graphs once again.


Organisation theory: an interdisciplinary approach


Oil extraction




Shipping or pipe

• •


• •


• •


Figure 10.1

In general we are asking the question as to whether a particular transaction should be internalised (make) or left in the market (buy), as depicted in Figure 10.2; that is, whether a point on the chain should be a department/ function or division or remain independent. For the moment we restrict our attention to this simple choice rather than the more elaborate positioning on the market–organisation continuum. We shall return to the more elaborate issue later on.

• •
Market (Price mechanism) Figure 10.2 Start by asking what the benefits and costs of using the market might be. The benefits could include the following: • Independent firms may be able to reap the benefits of economies of scale (i.e. operate at an output that minimises unit costs) whereas internal departments may not. Unless the firm itself can absorb all the efficient output of the department, it must either operate below the optimal output level or sell on to another firm. This might compromise any information advantages of the purchasing firm (see below). • Independent firms are more subject to market disciplines than departments and may hold down costs they can control more effectively. Costs may be difficult to identify in departments. Firms might, though, attempt to replicate market incentives inside organisations. Tapered integration refers to a situation where a firm is supplied...
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