Tthe transaction cost theory of vertical integration

In this paper I attempt to explain how successful Transaction Cost theory of vertical integration is in explaining why some businesses have moved into e-commerce faster than others. Please note that by ‘faster’ I do not specifically mean the speed at which the adoption has taken place. More emphasis is put on the extent of adoption and the extent of products or services offered online.

While there is countless literature on the impact of internet on transaction costs, very little is available explaining why vertically integrated firms may be at an advantage adopting e-commerce strategy. In fact it seems the only empirical study in the field has been carried out by Gartner & Stillman1, who analyze apparel industry in particular to identify several factors that contribute to this tendency. However it is limited in the sense that it considers B2C (business-to-consumer) e-commerce only, while B2B (business-to-business) is equally important, if not more. B2B will account for 83% of online sales in 2002 (IDC). C2C and C2B e-commerce lines are not very important at this stage due to their size.

Naturally there are two parts to the essay. The first part explains the transaction cost theory of vertical integration. The second part on the other hand tries to look at how helpful the theory is in explaining why vertically integrated firms have been faster in adopting e-commerce than non-integrated ones. I would like to point out at this stage to possible problems with finding support for the conclusions reached in this paper. The problem arises because we are looking only at one of the forces which determine why some businesses move into e-commerce faster and more importantly, to a greater extent than others. In fact there are many more other forces at work, indeed some in opposite direction to the one we are studying, which will determine firms’ online presence.

Indeed we could apply the same theory of transaction costs from the customer perspective to try to explain why different products face different customer acceptance in e-commerce1, which in turn determines why some businesses move online to a greater extent than others. However doing so would shift us from our particular area of interest. The point I am trying to get across here is that we have to be able to separate out these different forces if we want to get empirical backing for our argument.

Consider two firms, one integrated and one not, who produce similar goods. Just because statistical data indicate that they have the same level of online presence does not mean boundaries of firm do not matter as far as e-commerce adoption is concerned. It could simply be the case that transaction costs faced by customers purchasing goods online are higher for products of the integrated firm compared to the non-integrated one, for variety of reasons such as uncertainty or lack of information. One of these forces might outweigh the other obscuring the picture.

( I ) Transaction Costs and Vertical Integration

Broadly speaking, Transaction Costs are all costs of organizing and facilitating exchanges. They are not incurred by firms only. We as individuals incur transaction costs, (as small as they may seem) when we buy a packet of cigarettes from newsagent or purchase cinema tickets. They account for over one third of US economy and are even higher for less efficient economies. Transaction costs arise when it is in the interests of one party to act opportunistically at the expense of the other. The other party then spends time, money, time and effort writing and enforcing contracts to prevent this kind of behaviour. We have to note that if a firm does not suffer as a consequence of opportunistic behaviour, this does not mean it did not incur transaction costs. Costs of preventing the behaviour are very much part of transaction costs. On the other hand possibility of an opportunistic behaviour will raise the risk of a project, and hence the return required by investors.

The concept was first introduced by Coase4 in his famous article “The Nature of the Firm” in 1937. He argued that there must be some costs of using market which outweigh efficiency advantages of outsourcing when firms decide to vertically integrate.

Contracts are at the very heart of transaction costs economics. Contracts are preventive measures taken by parties involved in the transaction to safeguard themselves against opportunistic behaviour should one arise; they an essential part of private-ownership economy. Without contracts transaction costs would be enormous and economy would not move very far. In theory complete contracts would eliminate the costs of outsourcing as they would clearly specify each party’s rights and responsibilities for any type of situation that might possibly arise. But given three realities of life, namely bounded rationality, difficulties specifying and measuring performance and asymmetric information, complete contracts do not exist and transaction costs are very much reality of the markets. Contract Law will intervene to try to fill the gaps incomplete contracts have left out. Without proper contract law transaction costs would be huge as parties would try to write contracts as complete as possible, which would prove very expensive. This means the more effective the contract law in protecting parties against opportunistic behaviour the lesser the severity of transaction costs and greater the level of gains offered by efficiency of contracting-out.

Let’s look at some problems posed by transaction costs. There are several reasons for opportunistic behaviour. Let’s discuss some of them. Quite opposite to assumptions of perfect markets in real life not everyone possesses the same information. This is the case of imperfect information.

Three important concepts that help us understand why transaction costs may arise.

A relationship specific asset is an investment made to support a particular transaction, which cannot be put to another use without incurring extra costs, if it can be redeployed at all. Asset specificity implies quasi rents are positive. Quasi rent is the difference between the profit a firm will gain if the asset is put to its best use and the profit it would get if it was forced to redeploy it another use. If the asset did not posses design attributes it could be redeployed to another use without incurring any costs; quasi-rent in this case would equal zero. Now the possibility of quasi-rents can encourage the other party to act opportunistically and transfer part of these quasi rents to itself. Thus the problem of hold-up arises. Hold-up problems will discourage investment in relationship specific assets resulting in externality. In perfect world relationship specific assets would be preferred to non-specific ones due to efficiency gains.

So what are the implications of the Transaction Costs on the vertical boundaries of the firm? The higher the transaction costs the greater the benefits of internal governance structure implying greater level of vertical integration. How would vertical integration reduce the transaction costs? In three ways:

* Repeat relationships

* Sociological influences within the organisation

* Differences in governance

Having briefly looked through Transaction Costs Theory and its implications for boundaries of the firm we now try to explain why integrated firms might have an advantage over non-integrated firms as regards their e-commerce strategies.

( I ) Integration – an advantage in e-commerce?

E-commerce is a modern business practice associated with the buying and selling of information, products, and services via the Internet. Internet and other electronic communications have transformed the market place and relationship between companies, their customers, employees and business partners since mainly 1995. The concept is very much at the initial stages of development. Businesses have reacted differently to this technological change; some have been innovative while some are still sceptic. Here I have identified three major reasons from transaction cost point of view explaining the rather slow adaptation by non-integrated firms.

Coordination Costs

Gertner & Stillman suggest, quite rightly, that brick-n-mortar channels complement online channels and vice verse, in other words there are complementarities in multi-channel retailing. A good example of Multichannel Retailing strategy adaptation is Evesham.com, a PC manufacturer and retailer. The Evesham.com web-site is a powerful marketing and communication tool. It makes buyers aware of the brand, drives customers into shops, reaches distant markets otherwise unserved (geographically distant, e-shoppers, etc.), keeps customers up-to-date (through e-Newsletter) which helps customer retention, provides information, support, etc. Shops (or showrooms as they like calling them) on the other hand reduce customer transaction costs as potential buyers can physically examine goods before making online purchases, provide extra confidence in the brand, make returns (or collection) and servicing more easily available.

The situation is not an easy one for non-integrated firms, especially for ones who produce goods highly valued by customers for their intrinsic value, such as designer clothing. In this case how the product is presented to the customer is very much part of the package that the producer delivers. How the e-tailer presents the product on its web-site may change the customer’s perception and adversely affect the image of the brand. E-tailers on the other hand might want consistent design for their web-site. Negotiation costs will therefore be high for a non-integrated firm trying to distribute its products online. The best it can do is build a web-site which provides information about the products it produces and place direct links to recommended e-tailers’ web-sites where they can place orders. The web-site essentially enhances the customer experience and promotes the brand.

It can also offer post-purchase support depending on the nature of the product. A slightly different suggestion I make is for the vendor to incorporate their catalogue into e-tailer’s web-site. Users who click on the brand enter a sub-site (without leaving the retailer’s site) which has a design consistent with the image of the brand. If the customer then wishes to purchase a product their selection is simply saved to e-cart and transaction is handled by the e-tailer’s fulfilment system. Then again there are problems associated with monitoring the fulfilment services provided by the e-tailer. Because fulfilment is seen nowadays as important part of delivering value to the customer and one of the key components in customer retention, the vendor is taking a big risk by outsourcing. In this sense firms who had fulfilment systems already in place (such as catalogue retailing) when the e-commerce was first used as a commercial tool for the first time were at a clear advantage compared to the ones who did not integrate into distribution.

Companies who already had catalogue shopping systems, find it much easier to move into electronic distribution channel. This is because the latter shares similar characteristics with the former. The only difference is that customers now enter orders, payment and shipping details online as opposed to filling out paper forms or ordering over phone line. The only concern for the retailer here is fraud and security of sensitive data such as credit card details, etc. In fact once the order has been received the choice of channel does not make any difference how the order is processed. Given the problems listed above why not integrate into the order fulfilment services? Some, like SmarterKids.com have already done so, but there may be good efficiency reasons why these firms were disintegrated in the first place. Economies of scale can be a big constraint alongside agency costs.

One of the reasons why vertically integrated firms forward integrated in the first place was because their size allowed them low-cost distribution through economies of scale. Negotiation costs are low for integrated firms for two reasons. One is due to the fact that dispute resolution within integrated firms is much superior to those of non-integrated firms when it comes to e-commerce strategy. Second there are fewer brands to deal with. Non-integrated distributors have to negotiate new set of terms for every brand they wish to sell.

A very good example of integrated company who adopted e-commerce is Dell. Due to high asset specificity coordination costs are high for a company like Dell. No one order is the same as other, therefore integration is highly desirable to reduce transaction time and coordination costs. The same is true of Micron’s “Crucial Memory” subsidiary that produces RAM chips for many types of computers and sells memory chips through its web-site at crucial.com. Due to volatile nature of the industry quick response to demand is crucial.

Another reason why integrated firms might be quick going online is because of economies of scope in having similar technologies. Because of their size they might have installed network technologies such as intranet. E-commerce technologies require complementary investments which make it cheaper to be adopted by integrated firms compared to non-integrated ones. Also there is greater possibility that e-commerce technologies will be used in other parts of the business in integrated firms, for example for its B2B lines.

Channel Conflict

Channel Conflict between brick-n-mortar and internet channels is becoming a problem for manufacturers not integrated into sales force. One of the problems lies in e-tailers free riding on the promotional services provided by traditional retailers. Customers can consume personal services provided by these brick-n-mortar retailers while making the final purchase online. This happens mostly when the brands are well established and known, such as fragrances. When this happens manufacturers use various mechanisms, such as Retail Price Maintenance, to try to limit distribution online. This is not easily achieved however, due to antitrust laws and other restrictions. The ideal solution in this case would seem for the manufacturer to compensate the retailer for the sales effort. However this is not easily achieved due to monitoring costs.

Another solution would be for the manufacturer to offer online sales from its own web-site only, thus internalising the free-rider problem. This has its own disadvantages. Retailers may not like dealing with their competitors on the one hand, and the manufacturer may not achieve the minimum efficient scale for e-commerce to be economically viable on the other. An example of a company whose internet strategy was not welcomed by its retail customers is Levi Strauss who decided to sell its apparel online directly. Realising the channel conflict it then had to shut the online distribution down.

In some cases the reason why non-integrated firms have not moved into e-commerce is not so much because of channel conflict, but because of the inflexibility of such firms responding to environmental changes. Internal governance offers more flexibility in adapting to changes.

Externalities

A proportion of the profit made through online sales, in most cases the bigger one, will go to the manufacturer. Thus it would be appropriate for the manufacturer to make some contributions towards the investment made by the retailer for its e-commerce business. However the problems of free-riding discourage it from doing so. Once the main investment has been made to build e-commerce the marginal cost of adding support for new brands is almost zero (ignoring the transaction costs of doing so). When this happens manufacturers have incentives to free ride on investments made by others. This in turn leads to reduced investment in e-commerce.

On the other hand non-integrated firms might under invest due to high pressure for immediate returns from such investments. On the other hand the e-commerce strategy of integrated firms will be a long-term one, expecting to make losses at the initial stages due to lack of experience in the industry.

Conclusions

I have tried to identify some factors from the Transaction Costs point of view which might explain the e-commerce strategies of integrated and non-integrated firms. Coordination costs and incentive problems seem to be significant obstacles for non-integrated firms going online.

While the theory seems to be quite useful for explaining the tendency for integrated firms to be quicker in adopting e-commerce than non-integrated ones, there could be other forces we have ignored. Other issues such as payment security or technologies available could well be important determinants. It is difficult to tell at this point in time, when the internet is at the infant stages of its commercial use. Nevertheless Gertner & Stillman seem to be on the right track and I will not be surprised to see considerable research in the same direction.