How Capability Differences, Transaction Costs

This paper provides an integrative analysis of the drivers of vertical scope, and formalizes theory on capability-driven integration, focusing on the following questions: (1) How does the distribution of individual firm capabilities along a value chain affect vertical scope? (2) How do transaction costs interact with capability distributions in vertically linked segments to determine scope at the firm and industry level? (3) How do costs to growth in different parts of the value chain affect vertical scope? To answer these questions, I use analytical and computational methods to build an evolutionary model where firms set their vertical scope in a competitive context. Specifically, I propose a model with two vertical segments (upstream and downstream), firm populations with heterogeneous capabilities, and an intermediate market subject to transaction costs, where firms can choose freely if they are integrated or vertically specialized. By varying the level of transaction costs and changing the structure of the correlation of upstream-downstream capabilities in the industry, as well as of the costs of expansion, I generate numerical results that explain how vertical integration evolves over time. My results suggest that without capability differences, even if transaction costs are nil, firms remain integrated; transaction cost reduction is only relevant if there exists heterogeneity of firms along the value chain, or if there are bottlenecks (uneven limits to growth or costs of expansion) in different parts of the value chain. The model also explains “mixed governance” (concurrent use of the market and of integration) often observed in practice.