Vertical Integration: Applying an Economic Calculus to Knowledge

2 This paper applies an economic calculus to knowledge to address one of the most strategically important questions firms face – deciding which activities are more economically organized in a unified firm rather than in two autonomous firms. The conceptual and empirical framework presented here proposes that specialization leads to differences in cost and technical efficiency of knowledge-based factors of production between adjacent stages in a value chain. These divergent costs and technical efficiencies in turn shape the economics of inter-firm boundary location. A number of dimensions are suggested as being useful for distinguishing among the tacit, codified, and encapsulated forms of productive knowledge inputs. Knowledge, so classified, is substituted for labour and capital as factors of production in the traditional microeconomic isocost-isoquant model. The research framework being proposed implies that differences in knowledge-based factor intensities are instrumental in the determination of economic inter-firm boundary location. This paper is groundbreaking in its application of " an economic calculus to knowledge " (Simon, 1999: 34). It recognizes that " there are [factor] markets for knowledge… " and uses " …marginal rates of substitution between one form of knowledge and another " in applying microeconomic theory (Simon, 1999: 24). Evidence for the propositions would imply that those making decisions regarding the location of inter-firm boundaries should give consideration to knowledge-based factor intensities in making their decisions to optimize firm performance. Evidence found supporting the propositions would reinforce previous research suggesting the existence of a secular trend of increasing vertical de-integration of industries over time.