VI refers to the incorporation of two or more technologically separable stages of production in one firm and it can be distinguished in backward (upstream) and forward (backstream) integration. The TC theory can explain the size of the firms as well as their existence : transactions are internalised within a firm up to the point where the marginal reduction in TC is equal to the increased administrative costs. Hence it can also explain VI which is just a special case of internalisation of transactions. Indeed, the questions of why firms exist and why do we have VI are very closely related since all firms are in fact VI if one takes sufficiently narrow definition of production stages. The TC explanation of VI has been described by some as the "market failure" approach.
There are many reasons for which TC may be lower if some transactions are internalised in a firm. Coase mentions the costs of getting information on prices, the costs of negotiating and drafting a contract and the additional complications when long-term contracts are needed. Firms are able to lower TC because "one contract replaces many" as the firm managers are given discretion to act within certain limits without the need for new contracts to be made. Government tax policies may also encourage integration if, for example, it taxes market transactions but not internal ones. For Williamson the major reason is asset specificity which as we saw increases the costs of drafting a contract in a market framework. Integration may reduce TC associated with AS as the common interests moderate the disputes and as management can exercise its authority to put an end to protracted bargaining or to demand information from its employees.
Imperfect information is also very important and can affect firm size in many ways. Alchian and Demsetz pointed out to the difficulty in assessing individual contribution where we have team production but this is unlikely to be a factor in VI. Difficulties in checking imput quality (i.e. an externality for the upstream producers arising from asymmetric information) are likely to be more relevant for VI. Arrow argues that downstream producers have only limited information on imput prices so they find it difficult to make efficient decisions on imput proportions in their own production. This means that downstream producers have an incentive to acquire upstream firms but it is not clear why downstream firms are less able to predict the conditions of demand for imputs.
Carlton alternatively argues that uncertain demand for the final product, combined with rigidities in the upsteam industries, makes the latter to restrict their output so as to avoid having unused stocks, leading to imput prices above MC. Backward integration by downstream firms may thus occur to have the imputs at cost. To the extent that this simply involves a transfer of profits from the upstream to the downstream firm it is not a valid argument for VI unless they have better information of final demand and can make the upstream firm produce closer to the efficient level.
Chandler proposed that VI may occur because close co-ordination between imput-producers and distributors are necessary in order to maintain throughput. This will be particularly important for capital intensive industries with high fixed costs. Indeed Chandler has argued that this can explain the move towards VI of the big US and German manufacturing firms of the late 19th century. Another possibility is that VI is required to support innovation. This may be due to the lower finance costs of large firms (which could perhaps be incorporated in TC analysis to the extent that this is because banks are able to spread more the TC when dealing with big firms or because small firms involve more search costs for the bank to check if they are trustworthy or not). Furthermore, distributors and imputs producers may lack information about new products and persuading them may be expensive (eg. market surveys etc.).
As we have also said with AS, the complexity of contracts obviously encourages integration. Usher's explanation of firms as arising from the division of labour could be included here since otherwise enormously complex contracts would have to be made with each specialised factor of production. More related with VI, when technological factors make it advantageous to have many stages of production in one plant, TC would be minimised if all of these stages were organised by the same firm.
The costs of the firm -and hence of VI- are that there exist diminishing returns to the entrepreneur who will be less and less able to use his discretion to efficiently organise, place and monitor factors of production. Coase also pointed out that as the firm expands it will have to undertake increasingly dissimilar transactions and organise increasingly spatially distributed factors of production, making the managers' role even more difficult. This can be particularly important in the case of VI since it may involve a radically different production process. Thus, any improved managerial techniques and any innovations such as telephone which reduce the spatial distribution of factors will generally lead to an increased firm size (though in the later case the TC of using the market would also fall so the result may not be as clear cut).
Furthermore, Coase argued that the expansion of the firm may lead to increases in the supply price of factors of production such as people preferring to work as directors in a small firm rather than department heads in a large one but this is debatable since this may work the other way round as large firms may secure lower imput prices or cheaper finance. Williamson argued that firms lack the "high-powered internal incentives" of the market. Managers in a firm will not be able to match market incentives since ex post it is often optimal to forgive the worker who, for example, made a mistake while there are often problems with the incentives of the managers themselves (the principal-agent problem). Moreover the central authority can be corrupted leading to inefficient decisions as well as in a waste of resources in the attempt to corrupt it; presumably the larger the firm the greater the resources spent in trying to influence its management.
The implication of the TC approach is that, in Coase's words "we have an optimal amount of planning" though Williamson has been more cautious having institutions "economising" rather than minimising TC. Thus, government should not try to prevent VI but instead treat equally market transactions and internal-to-the firm transactions and try to reduce TC through the dissemination of information, appropriate monetary arrangements, assigning property rights and improving the efficiency of law enforcement. As we shall see, however, the New Institutionalist approach has been criticised on a number of grounds.
Fisher and Dalhman criticised it in that it can be used to explain anything and indeed we saw how widely different theories of VI were incorporated in the TC framework. The comparative statics nature of the theory is also under fire for not explaining how the "optimal" arrangements are universally obtained, especially given bounded rationality. Thus it is argued that an evolutionary framework would be more appropriate but again there has been some debate over whether the firm can be "a unit of evolutionary selection". There are also possibilities of path- and context-dependence in such an evolution which imply that the socially efficient outcome may not be reached (or it may not be unique). The theory also ignores possible short-run Vs long-run trade offs in efficiency including an analysis of the interdependence between production technique and organisational form. Chandler, Puterman and Loasby put forward theories where there is endogenous development of firm and market "capabilities" though these are not directly related to VI. Furthermore, the nature of transactions may not be completely exogenous and the development of technology could satisfy other motives.
The most important criticism of the New Institutional Economics is their neglect of power considerations. In the case of VI it is widely believed that one of the main motives is the monopolistic one, i.e. obtaining/increasing market power. Traditional neoclassical analysis suggests that it is possible that, ignoring efficiency gains, VI will lead to higher prices and higher monopoly profits provided the downstream industry can vary its imputs ratios. It should be noted though that if these ratios are constant - which some consider a plausible assumption for the short-run- VI could even lead to a fall in price.
This analysis, however, assumes that the firms where each receiving full monopoly profits in their industries. If they weren't because of the fear of entry, VI can be used as barriers to entry, thus leading to higher prices. VI can be barriers to entry only if all incumbents are integrated so that new entrants will have to be integrated as well so that it raises the capital requirement for entry. This is said to discourage entry because it increases risk and leads to more expensive finance. The counter-arguments, however, are that this won't be a barrier to large firms diversifying while the higher profits of the incumbents will attract entrants (the "comparative markets" theory). Other arguments are that integrated firms have increased opportunity to vary the specification of imputs while if incumbents control strategic markets or supplies entrants will be forced to use lower quality facilities. Further more if the minimum efficient scale of production in one industry is much higher than in the other and the entrant has to enter both, VI is clearly a barrier to entry. VI can also be a barrier to entry if there exists a government-imposed barrier to entry in one industry and entrants have to enter both. It should be noted though that in such cases the policy implication may be to remove these artificial barriers rather than oppose VI.
Another possible reason for VI is that it may be used to facilitate price discrimination in cases for example when an upstream producer sells to 2 downstream groups with different price elasticity but cannot charge different prices, so he buys the low elasticity group in order to separate the market. In any case, price discrimination often increases output so it is not clear if it is socially desirable though the redistribution of income may not be desirable. Finally, another reason for VI is to circumvent government regulation by transferring profits from the one industry to the other.
Concluding, the TC theory in its many forms does seem to provide both a flexible (perhaps too flexible!) and plausible framework to understand the occurrence of VI as well as a powerful argument for government non intervention; even if monopolistic considerations do exist, it is still not clear that VI is socially detrimental since the gains from lower TC may outweigh the efficiency losses from increased monopoly power. Thus the advice to the government that it should have a case by case attitude towards VI (as it indeed it does) which does not seem to suggest that TC analysis has after all revolutionised microeconomics.
