Vertical Integration in Competitive Markets Under Uncertainty

Abstract

At a more theoretical level, several authors concerned with industrial organization have suggested that uncertainty could provide an incentive for vertical integration.As early as 1937, Coase argued that with constant returns to scale in production the very existence of a firm de- pends on some sort of market imperfections.The firm organizes when its internal allocative ability is superior to that of a market.Coase claimed that uncertainty about finding sellers of factors of production could provide one justification for the existence of a firm.ApplyingCoase' s reasoning to the question of vertical integration many years later, 2 Malmgrem indicated that the presence of uncertainty could create incentives for vertical integration."Activities which tended to fluctuate, causing fluctuations in prices and outputs in the market, could be integrated 3 and balanced against one another."Malmgrem argued that when prices do not reflect scarcity, vertical integration can occur.More recently, 4Williamson discussed how uncertainty can make it difficult to establish contracts, and could provide incentives for vertical integration.None of the discussions ever address the issue of whether vertical integration is a socially desirable response to the uncertainty in the market.Until very recently, there had been no attempt to analytically investigate the claims of the above authors as regards the effect of uncertainty on the incentives for vertical integration.Recently, two economic theorists have sought to bridge the gap in the literature.