This article focuses on antecedents of vertical integration. A model of vertical integration derived from transaction cost economics and the resource-based view is tested empirically with data from the mechanical maintenance services market in the hydroelectricity industry. The results show that asset specificity and closeness to present competence are positively related to vertical integration, while tacit knowledge is negatively related to vertical integration. The positive interaction effect between asset specificity and closeness to present competence on vertical integration is also supported, indicating that the decisions on insourcing and outsourcing can benefit from using transaction cost economics and the resource-based view in tandem.
Purchasing and supply management are strategic functions of the firm which includes insourcing and outsourcing decisions of the firm. Strategies and decisions regarding insourcing and outsourcing are the starting point of an effective purchasing and supply management function. Axelsson et al. (2005, p. 5) argue that:
First, it should consider whether to outsource specific processes or not, or whether it should insource processes presently performed by outside suppliers. Once that decision has been made to outsource, or keep as outsourced, the next step is to develop a commodity strategy for each specific item.
Insourcing and outsourcing decisions are results of a continuous process where the firm evaluates factors that affect vertical integration to make the most efficient operations. The knowledge about the key factors that affect these decisions is therefore critical to effective purchasing and supply management, for both purchasing managers and others that are involved in “make or buy” decisions of the firm.
Theoretical and empirical work devoted to explaining insourcing and outsourcing decisions, also termed vertical integration, or organizational boundary decisions, has taken a number of different approaches. Two important perspectives are transaction cost economics (Williamson, 1985 and Williamson, 1991) and the resource-based view (Barney, 1991; Conner and Prahaled, 1996; Grant, 1996; Kogut and Zander, 1996). Both perspectives focus on efficiency considerations, but they pay attention to different factors when explaining how firm boundaries are determined. Transaction cost economics (TCE) focuses on market failures resulting from asset specificity as the main reason why firms choose to vertically integrate activities (Williamson, 1985 and Williamson, 1991). However, it has also been argued that, when studying vertical integration, there is a need for theories that can explain the limits of firm size beyond the market failure argument (Wiggins, 1991). Several researchers consider the resource-based view (RBV) as a suitable perspective for this issue (e.g., Barney, 1996; Conner and Prahaled, 1996). This stream of literature focuses on organizational resources and competencies. It emphasizes performance gains that result from assessing the internal capabilities and competencies that are important for understanding boundary decisions (Argyres, 1996).
Efforts to merge the TCE and RBV approaches have been requested in the literature (e.g., Conner and Prahaled, 1996; Santos and Eisenhardt, 2005; Williamson, 1999). In particular, Santos and Eisenhardt (2005, p. 503, emphasis added) argue for a new research agenda where future research on vertical integration and organizational boundaries attempts to integrate the two theoretical perspectives:
Existing empirical work on organizational boundaries often attempts to validate single theories such as TCE. Recently, emphasis has shifted to research that frames boundary conceptions as competing alternatives (Argyres, 1996; Poppo and Zenger, 1998). While this research is clearly valuable, many intriguing insights are likely to come from studies that explore relationships (not competition) among boundary conceptions. Indeed, combining conceptions may be a more valid view of how they actually operate in organizations.
Accordingly, this paper presents the development and test of a model that draws upon central aspects of both TCE and RBV. This model offers an explanation of vertical integration that considers variables from both inside and outside of the firm. This approach addresses the need for a more comprehensive set of explanations for vertical integration and also proposes a synergistic use of the two perspectives. TCE and RBV have been used jointly in recent purchasing and supply management studies to investigate strategic-level purchasing and buyer–supplier relationship issues (e.g., Wagner, 2006). Use of the two theoretical perspectives together increases our understanding of the relationships and trade-offs among factors that affect effective purchasing and supply management decisions regarding insourcing and outsourcing.
We posit that asset specificity (from TCE) and relatedness (from RBV) are the major determinants of vertical integration. Furthermore, we argue that relatedness is composed of closeness to present competence (or just “closeness”) and tacit knowledge. Closeness captures the similarities between (1) a firm's present knowledge and skills and (2) the knowledge and skills required for integrating activities into the firm that are performed by suppliers. The theory also posits that an interaction effect exists between asset specificity and closeness which represents a synergy between TCE and RBV that is unique. This study extends the role of asset specificity in this context and discusses potential conflicts between the TCE and the RBV approaches. Four hypotheses are empirically tested in the mechanical maintenance services market using purchasing firms in the hydroelectricity industry. The focus of the empirical study is on the likelihood of buyers integrating activities currently purchased from external suppliers. In addition to the theoretical contribution, the study also presents two new and alternative measures of closeness.