Technical Change, Competition and
Vertical Integration
Srinivasan Balakrishnan and Birger Wernerfelt
Strategic Management Journal
BADM 546, Group #1
Meredith Blumthal
Wooje Cho
Barclay James
Kumar Sarangee
Overview
Research Question:
Why would certain investments in the long run be
more attractive to integrated firms than to independent
suppliers?
Vertical Integration
The combination of technologically distinct production,
distribution, selling and/or other economic processes
within the confines of a single firm… a decision by the
firm to utilize internal or administrative transactions
rather than market transaction to accomplish its
economic purpose. (Porter)
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Theories of Vertical Integration
Economies of Integration
The strategy of integration will be preferred:
• Competitive Considerations: when integration introduce
entry or mobility barriers to competition resulting in higher
revenues to the integrated firm
• Production economies: when there are production
economies of scope
• Transactional economies: when there are transactional
economies in integration
• Investments in specialized assets and technological
change: if the technology is expected to be relatively shortlived, the decision not to integrate is correct
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A Simple Model
A firm’s integration strategy depends on:
Competitive considerations
Market transaction costs
Bureaucratic diseconomies
Technological instabilities
Model for firm’s profitability and integration
π (v) = vps [1 - m (1 - v) - bv]
v: faction of being selected parts of the value-added
chain in the industry
s: market share (p*s: basic level of profitability in the
industry
m: fraction of the profits lost in market transactions
b: fraction lost in bureaucratic transactions
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A Simple Model
Expected Net Present Value of all future profits

NPV   e e
 rt t / T

 (v)dt   e  rt (1  v)idt
0
0
1
i
NPV 
 (v)  (1  v)
r 1/ T
r
Optimal level of integration v*
1
11
v*   0  1   2
s
T s
1 m
0 
0
2(b  m)
i
1 
0
2 p (b  m)
i
2 
0
2 p (b  m)r
•T: expected time to the innovation
•r: discount rate
•i: the rate of investment elsewhere
except the internal value-added chain
•m: fraction of the profits lost in
market transactions
•b: fraction lost in bureaucratic
transactions
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A Simple Model
Three separate cases:
When v* = 0
• The firm would prefer a negative level of participation
• Very common case
• No firm participates in all industries and can thus be said to
have decided against participation in some industries
When v* = 1
• The firm would prefer to invest more than the maximum
feasible amount in the industry
• Very rare case
• Ex. Some petrochemical firms
When 0<v*<1
• Need to find optimal value of v* (optimal level of vertical
integration)
• The empirical study of this paper focus on the case
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Empirical Test
Purpose: Analyze the effect of technological
instability (1/T) and the market share of a
representative firm (s)
Analysis level: industrial level
Assumptions
p, b, m, r, and i are similar across industries
The linear relation between equilibrium market share
and profitability may be reasonably valid across
different industries
Testing Model
vi = β0 + β1 (1/s) + β2 (1/s) (1/T) + ei
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Empirical Test
Measuring
Level of vertical integration (v): a vertical
integration index which measures the proportion
of economic process carried out within the firm
Market share for a representative firm (s): MES
(Minimum economic scale)
Mean life of the process technology (T): average
age of plant and equipment in use
Data
93 SIC-4 digit level manufacturing industries which
are randomly selected from among the 261
industries included in the FTC Annual Line of
Business Reports
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Empirical Test
Results
The results are consistent with the theoretical
expectation
Level of vertical integration decreases as
competition goes up
• By lowering the entry barriers
Integration levels are lower in industries
characterized by frequent technological
changes
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Conclusions
Especially if the degree of competition is high,
integration is affected negatively by the
frequency of technological change
The optimal level of integration depends
negatively on the degree of competition in the
industry
However, vertical integration strategy is a
complex and controversial topic, so simpleminded rules of thumb are potentially misleading
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