Dynamic Transaction Costs and Firm Boundaries in the Soft Drink Industry

INTRODUCTION There have been numerous articles in the business press identifying an increase in the number of vertical mergers. This increase in activity has sparked a debate over whether these mergers represent a general movement towards vertical integration, reversing several decades of outsourcing and vertical disintegration (Gross, 2006; Denning, 2009). Despite differences in opinion over trends, observers agree that, unlike the large corporations of a hundred years ago, current efforts are not leading to full-blown vertical integration. "Today's approach is more nuanced. Companies are buying key parts of their supply chains but most don't want end-to-end control" (Worthen, et. al., 2009). These articles have put forth a variety of explanations for this increase in "selective vertical integration" (Gross, 2006). One is that rising commodity prices (and price volatility) have spurred manufacturers to purchase suppliers of commodities. "Having bulked up acquiring rivals, manufacturers are turning their deal making prowess to raw materials providers in hopes of ensuring adequate supplies and controlling costs" (Aeppel, 2006, A1). The current economic downturn has also been cited as an important rationale for backward integration. By threatening the economic viability of suppliers, the recession has created a high degree of uncertainty for downstream firms who rely on upstream producers for inputs and raw materials (The Economist, 2009). For both these situations, backward integration represents a defensive strategy to prevent costly interruptions in the supply chain. Such efforts resemble one of the major rationales for the emergence of large, vertically integrated corporations during the late 19th and early 20th centuries (Chandler, 1977). In addition to ensuring supplies, a recent Wall Street Journal article identifies "control" as an important motive for vertical acquisitions for firms in diverse industries. Live Nation seeks to buy Ticketmaster to have greater control over event promotion and ticketing; PepsiCo purchases Pepsi Bottling Group to capture greater control over beverage distribution; and Boeing merges with Vought Aircraft to gain greater control over manufacturing (Worthen, et. al., 2009). Such claims beg the question why contractual measures failed to provide the requisite "control" for buyers. The recent flurry of vertical mergers and the awarding of a Nobel Prize in economics to Oliver Williamson in 2009 present a propitious opportunity to assess the explanatory power of economic theory in depicting the vertical boundaries of firms. In looking at these recent mergers, a cogent theory would be able to explain why above firms found pre-merger contractual relationships unsatisfactory while being able to describe how integration addressed those shortcomings. In other words, economic theory needs to conceive firms and contracts as alternative governance structures and discuss the conditions under which each structure would be optimal from an efficiency perspective. Organizational economics generally portrays decisions to integrate (or to outsource) as contingent ones, depending upon the characteristics of the firm (and industry), specific attributes of a transaction and the circumstances of the time. This paper examines alternative approaches within organizational economics in the light of recent empirical experience to see which theories best stand up to scrutiny. The dominant approaches emphasize transactions costs and agency costs in determining the vertical boundaries of the firm. Both of these approaches see firms as organizational structures that address incentive problems that often plague market-based (or contractual) relationships. This paper argues that the narrow focus on incentives has ignored the role of firms in addressing coordination problems associated with arm's length exchange. Firms often facilitate the coordination of complementary activities along the supply chain that require very different types of know-how. …