Proceedings of European Business Research Conference
Sheraton Roma, Rome, Italy, 5 - 6 September 2013, ISBN: 978-1-922069-29-0
Differentiation Strategies, Transaction Costs and
Capabilities as Determinants of Vertical Integration
Marta Fernández Olmos and Jorge Rosell Martínez
This study evaluates the importance of a product differentiation
strategy as a determinant of vertical integration in the firm. The
proposed model also controls for known determinants of
integration such as transaction costs and firm-level capabilities.
By
identifying
transaction-,
firmand
strategy-level
determinants, we derive testable predictions about the choice of
vertical integration. To test these predictions we analyze the
case of the Rioja wine industry with a representative sample of
187 firms. In general, empirical evidence indicates that firms
vertically integrate to mitigate opportunism, to deal with
unforeseen contingencies, to internally exploit their capabilities
and to improve their success in vertically differentiating their
products.
Keywords: Transaction Cost Economics,
Differentiation, Vertical Integration.
Resource
Based
View,
Product
JEL: L22
Introduction
The organization field is fundamentally concerned with explaining differential
firm´s boundaries, which represents a question of great strategic importance for its
managers (Butler and Carney, 1983; Leiblein et al., 2002; Díez-Vial, 2007). Indeed,
understanding why some firms produce a good or service themselves while others
procure it from another organization is one of the central questions in industrial
organization.
A large number of explanations for the vertical integration decision have been offered.
In the strategic management literature, a high degree of vertical integration between
the links in the value chain is emphasized as a success factor for quality control and
innovation ability (Porter, 1980). That is, vertical integration may be an adaptive
response to a product differentiation strategy that is driven by rapidly changing
markets, new technologies and an almost worldwide competition. Some economists,
though, have emphasized the decision of vertical integration is based on economising
on transaction costs. As asset specificity becomes substantial, bilateral dependence is
deepened and vertical integration will be relatively more efficient because of its
coordination capacity (Williamson, 1979). Finally, the basic assumption underlying the
resource based view is that vertical integration may be pursued by a firm competing to
achieve competitive advantage property and to increase the chance to be able to
appropriate economic rents or to guarantee rare, difficult to imitate and costly
resources (Barney, 2002).
________________________________________
Marta Fernández Olmos, Department of Business and Economics, Faculty of Economy,
University of Zaragoza, Spain. Email: maferno@unizar.es
Jorge Rosell Martínez, Department of Business and Economics., Faculty of Economy,
University of Zaragoza, Spain.
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Proceedings of European Business Research Conference
Sheraton Roma, Rome, Italy, 5 - 6 September 2013, ISBN: 978-1-922069-29-0
While all cited points of view have contributed to our understanding of vertical
boundaries of the firm, each approach offers managerial prescriptions that are
individually incomplete. We contend that if followed in isolation, each framework can
lead to inferior performance.
This paper tries to improve upon prescriptions from the literature by constructing
and testing a model that integrates several views in a single framework. In doing so,
the paper extends the empirical literature in vertical integration by examining the
relative economic and statistical importance of these prescriptions associated with
strategic management literature, transaction cost economics and the capability-based
view. We seek to offer a complete and accurate understanding of how firms establish
their vertical boundaries and resolve the trade-offs involved in the different
explanations.
Many empirical studies of vertical integration decisions testing transaction cost
economics have found support for the theory’s main hypotheses. As compared with
transaction cost economics, much fewer empirical papers that have examined the
effects of firm’s capabilities on the vertical boundaries of the firm. Some of these recent
studies have suggested that vertical integration is conditioned not only by transaction
costs but also by production cost differences (Argyres, 1996; Jacobides and Winter,
2005; Madhok, 2002). Finally, in strategic management literature most studies have
focused on discussing specific strategic issues associated with vertical integration in
the value chain. These include improved ability to differentiate the product and
increases in product and process quality (e.g., Kumpe and Bolwijn, 1988; Kindel,
1991). It is therefore remarkable that the empirical literature throws so little light on how
product differentiation strategy creates motivations for firms to vertically integrate. To fill
this gap, this work also contributes by analysing the role that product differentiation
strategies play in determining vertical integration in addition to other factors.
Traditionally, discussions of vertical integration have focused on manufacturing
(e.g., Anderson and Schmittlein, 1984; Ohanian, 1994; Bigelow and Argyris, 2007;
Parmigiani, 2007). This leads to emphasis on the valuation of production costs, which
may be or may be not higher under vertical integration. Although it has recognised that
differences in quality are increasingly relevant, less attention has been paid to their
role. We focus on the integration of a particular agrarian activity, viticulture. The issue
is whether to buy grapes from independents growers or to cultivate grapes in own
vineyard. The resolution of this issue turns on quality differences, because differences
in production costs are negligible in this setting.
In other words, the aim of this paper is to evaluate the importance of a product
differentiation strategy in the firm as a determinant of its vertical integration decisions,
accounting for other well-known determinants as those from transaction cost
economics and from the resource based view. We test our hypothesis on Rioja wine
industry. This industry offers some advantages as a research case. Its main input
(grapes) is a non standardized supply; it is a relevant world known producing region;
vertical product differentiation may be objectively determined; it offers enough
variability among firms; and finally, it is a bounded industry so a highly representative
sample is achievable.
The paper proceeds as follows. Section 2 discusses the theoretical framework
for understanding vertical integration decisions, integrating three main approaches:
transaction cost economics, resource-dependence theory and industrial organization.
Section 3 describes the data and methodology used to test these hypotheses. A
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Proceedings of European Business Research Conference
Sheraton Roma, Rome, Italy, 5 - 6 September 2013, ISBN: 978-1-922069-29-0
discussion of the results is obtained in the fourth section. Finally, section five presents
the main conclusions of the study.
Theoretical Framework
There is no shortage of factors of the occurrence of vertical integration. Economic
theory, as well as empirical literature, has shown that vertical integration may be
induced by transaction costs, the development of strategic capabilities and even by the
choice of a differentiation strategy. Nevertheless, compared with transaction costs and
capabilities, there are fewer empirical studies that provide evidence of differentiation
strategy as determinant. All these determinants are jointly explored in our model.
Vertical Integration and Transaction Costs
Research on transaction cost theory maintains that there are hazards associated
with conducting certain kinds of transactions through the market, and that these kinds
of transactions will therefore be performed more efficiently within a firm (Coase, 1937).
Williamson (1985) and Klein et al. (1978) suggest that the main contractual hazard is
hold-up, whereby the party whose investments in the transaction can be freely
transferred across applications expropriates quasi-rents from the party who invested in
transaction-specific assets that are non-valuable in alternative uses. TCE predicts that
internalization, or hierarchy, may reduce the potential for such opportunistic behavior
by reducing the incentive for contracting parties to engage in hold-up, in part by
creating an environment in which “adaptive, sequential decision-making” supported by
the threat of fiat may occur, and where the courts forbear from intervening (Williamson,
1975, 1991). Internalization, however, implies added bureaucratic costs and lowerpowered incentives (Williamson, 1985). Therefore, we can advance that:
Hypothesis 1: The greater the potential transaction specificity of assets, the
greater the likelihood of using vertical integration.
The earlier model developed by Williamson (1975) proposed other three
important factors that also drive integration decisions, namely transaction frequency,
uncertainty, and small number bargaining.
According to Williamson (1975), transactions characterized by small numbers
bargaining are also hazardous because such transactions are more subject to
haggling, delay, and other strategic behavior by the parties when contractual
disturbances arise. The evidence to support the hypothesis that vertical integration
rises with supplying industry market concentration, even controlling for asset specificity,
has been obtained in various prior studies (e.g., Levy, 1985; Caves and Bradburd,
1988; Leiblein et al., 2002). In terms of food industries, Frank and Henderson (1992)
and Bhuyan (2005) find supporting evidence for vertical integration in the U.S. food
manufacturing industries. Accordingly, the small numbers bargaining hypothesis is the
following:
Hypothesis 2: The smaller the number of suppliers in the upstream market, the
greater the likelihood of vertical integration by downstream producers.
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Proceedings of European Business Research Conference
Sheraton Roma, Rome, Italy, 5 - 6 September 2013, ISBN: 978-1-922069-29-0
A basic assumption of transaction cost theory is that all transactions are
conducted under a certain level of imperfect information1, which can affect exchanges.
Environmental uncertainty appears when the circumstances surrounding the
exchange cannot be specified in advance. This complicates writing contracts since
parties will have to devote a lot of time trying to identify the diverse contingencies that
may arise. Nevertheless, although transactions will be completed less smoothly than in
more certain environments, the market mode is still advantageous. Hence,
unpredictability per se does not favour vertical integration, only in interaction with asset
specificity (Williamson, 1979; 1985). This interaction effect between unpredictability
and asset specificity have been found by Anderson (1985), Coles and Hesterly (1998),
Fan (2000), Leiblein and Miller (2003) and Díez-Vial (2007). The following hypothesis
can therefore be proposed:
Hypothesis 3: The greater the environmental uncertainty, in the presence of
asset specificity, the greater the likelihood of using vertical integration.
A second form of uncertainty, which is linked to difficulty of evaluating
performance2, is recognized in Williamson´s later writings (1981) as “internal”
uncertainty. Contracting parties should be able to evaluate the service or product being
exchanged. If performance cannot be easily assessed, the market will fail because
what to reward and how is not known (Williamson, 1981). Based on this reasoning, we
hypothesize that increased internal uncertainty in the transaction will lead to an
increased use of vertical integration. This general hypothesis has gained some degree
of support in empirical research (e.g. Anderson and Schmittlein, 1984; Anderson, 1985;
Gatignon and Anderson, 1988; John and Weitz, 1988; Majumdar and Ramaswamy,
1994).
Hypothesis 4: The greater the internal uncertainty, the greater the likelihood of
using vertical integration.
Frequency refers to the regularity of the transaction. For the purposes of this
particular study, however, we do not measure the effects of frequency because all
transactions that were examined occurred with the same frequency.
Besides specificity and uncertainty, Williamson (1981) agrees that other factors
are also bound to operate in a given setting. In particular, Williamson (1974) points to
diseconomies of scale as a factor limiting the extent of vertical integration. This is
because internalization comes at the cost of additional bureaucracy and lower-powered
incentives (Williamson, 1985). Empirical evidence has been provided to support this
idea (Martin, 1986; Scherer and Ross, 1990; Russo, 1992; Bhuyan, 2005). All of this
leads us to consider the following hypothesis:
Hypothesis 5: The larger the firm is, the smaller the likelihood of using vertical
integration.
Vertical Integration and Firm Capabilities
The resource- and capability-based view of the firm emphasizes the management
of a firm’s resource and capability portfolio as a key determinant of the configuration
1
It is a necessary condition for asset specificity to induce vertical integration. Without uncertainty, a perfect contract
covering full contingencies could be written and hence, there is no need for vertical integration (Fan, 2000).
2
Alchian and Demsetz (1972) refer to this concept as the difficulty with which individual productivity can be
metered.
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Proceedings of European Business Research Conference
Sheraton Roma, Rome, Italy, 5 - 6 September 2013, ISBN: 978-1-922069-29-0
and boundaries of the firm. This view has provided additional theoretical and empirical
explanations of vertical integration decisions. The central premise of this framework is
that firms are heterogeneous in terms of the resources and capabilities they own and
control (Schumpeter, 1942; Penrose, 1959; Wernefelt, 1984). This heterogeneous
character of resources can be determined by factors such as resource-market
imperfections (Barney, 1991), inability to alter the accumulated stock of resources over
time (Carroll, 1993) or difficulty to imitate (Dierickx and Cool, 1989). Capabilities refer
to those abilities, organizational processes, knowledge and skills that allow a firm to
combine its resources to achieve superior performance over competitors (Amit and
Shoemaker, 1993; Grant, 1996, Prahalad and Hamel, 1990). Within this line of
reasoning, vertical integration decisions may be led by firms´ attempts to leverage and
protect idiosyncratic capabilities. Argyris (1996) tested this theory using several
examples from a manufacturing firm. The findings support the proposition that firms
outsource when suppliers possess superior capabilities, except when higher costs are
accepted in the short run while capabilities are being developed in-house. Likewise,
Poppo and Zenger (1998) empirically linked the presence of skill sets to vertical
integration decisions. Barney (1999) suggests that integration decisions are jointly
determined by the expected cost of opportunism associated with accessing a factor
through the market-place as well as the expected cost of creating that factor inside the
firm. Hence, a firm that owns innovation and marketing skills, which are valuable 3 and
difficult-to-imitate capabilities due to their intangible nature, will be more likely to
integrate than its competitors. Therefore, we hypothesize:
Hypothesis 6: Marketing-intensive firms are more likely to choose integration for
their transactions.
Hypothesis 7: Innovation– intensive firms are more likely to choose integration
for their transactions.
With the constant pressure to meet consumer demands and the need to be
competitive, firms must continually acquire, develop and upgrade their resources and
capabilities (Wernefelt and Montgomery, 1988; Robins and Wiersema, 1995; Argyris,
1996). Hence, the identification of the origin of strategic resources and capabilities
(those that establish and enhance the firm´s sustainable competitive advantage)
represents one of the most complex challenges facing a firm. Although some authors
ascribe capabilities to luck (Barney, 1986), resources and capabilities are traditionally
considered as the product of a history of specific routines developed experientially at
the firm. They are said to develop cumulatively, as firms learn to perform routines over
time (Nelson and Winter, 1982; Amit and Schoemaker, 1993). As a result, some
authors hypothesize that a firm with production experience will be more likely to
integrate because it provides learning opportunities that enhance its production
capabilities (Arrow, 1962; Conner, 1991; Leiblein and Miller, 2003).
Hypothesis 8: The greater the experience of the firm, the greater the likelihood
of vertical integration.
3
Marketing skills may enhance the ongoing relationship between customers and a brand thus increasing the
competitive advantage of the firm (Larsen and Srinivisan, 2003). With respect to innovation capability, investments
in R&D may lead to the development of superior product designs also increasing the competitive advantage of the
firm through product differentiation (Kotabe, 1990).
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Proceedings of European Business Research Conference
Sheraton Roma, Rome, Italy, 5 - 6 September 2013, ISBN: 978-1-922069-29-0
Vertical Integration and Product Differentiation Strategy
A well-known product strategy in mature markets is differentiation. Mature
industries become more dynamic and more complex, what accentuates the degree of
interdependence among different levels of the supply chain. Market directedness of
product and services and the efficiency and reliability of their delivery become decisive
aspects for competitiveness chain (Ziggers and Trienekens, 1999). It explains that a
product differentiation strategy based on high quality performance has become a
cornerstone of many firms´ competitive strategies.
Strategic management literature has abundant studies that focus in a variety of
benefits of vertical integration that influence the product differentiation. A common
issue is that increased control over adjacent stages may enhance the ability of a firm to
differentiate its product (Perry, 1989; Porter, 1980; Buzzell, 1983). It can be
distinguished specific strategic issues associated with integrating forward and
backward in the value chain. Whereas backward integration may allow the firm to
obtain specialized inputs through which it may improve or at least distinguish its final
product, forward integration gives the firm better or more timely access to market
information, allowing a more rapid or specified adjustment of product to consumer
demands (Porter, 1980; Ouden et al., 1996). Therefore, this strand of the literature
argues that firms that seek a product differentiation strategy are motivated to vertically
integrate because this decision allows them for product quality improvements through
control of input quality and distributions and service of outputs (Johnston and
Lawrence, 1988; Hill and Jones, 2008). Based on this reasoning, we establish the
following hypothesis:
Hypothesis 9: The more differentiated the product of the firm, the larger the
likelihood of vertical integration.
In summary, we hypothesize that firms vertically integrate in order to: (1) mitigate
ex-ante (small number) and ex-post (asset specificity) opportunism; (2) deal with
unforeseen contingencies in transactions; (3) avoid opportunist behavior due to
measurement problems; (4) internally enhance their capabilities; and (5) improve the
performance of their differentiation strategy (see Figure 1).
INSERT FIGURE 1
Empirical Analysis
The Case Study
Wine industry may be considered a mature market in most developed countries.
A singularity of this world market is that among the most important competing actors
are regions, e.g. Bourgogne, Rioja, Champagne, Sherry, Oporto and so on. Regions
act as industrial districts that base their competitive advantage in a collective
reputation, or collective brand, of quality and differentiation among them.
The concept of collective reputation is directly applicable to the protected
designation of origin labeled products. Since many individual wine producers are not
known directly by the consumer, consumers tend to rely on the image of the collective
brand that guarantees and promotes the particular label. For all those belonging to the
label, this collective reputation acts as a public good. Then, if the collective reputation
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Proceedings of European Business Research Conference
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of the product is excellent, a label with the indication of its origin will be a powerful tool
to signal quality as well as other attributes and perceptions. Moreover, the
implementation of a label with collective reputation as those cited previously will reduce
the search costs associated with the consumer´s choice (Loureiro and McCluskey,
2000). For this reason, wineries have a high incentive to belong to an appellation of
origin. But to do it, high standards of quality control and management must be assured
by wineries of the region. This kind of rules and standards are established and
controlled by a board which is responsible of the label and the registered trade mark.
Rioja is a wine producer region with a protected label DOCa Rioja (Denominación
de Origen Calificada Rioja). It is well known for its red wines with traditional elaboration
methods. Nowadays there are about 600 wineries, and about 10,000 growers (not
associated in cooperatives), with an annual production of about 280 mill. liters of wine.
It was selected one region, rather than several, because a wide variability in the
business inside this region is detected. This design allows to establish internal validity
(Anderson, 1985). In this sense, though quality standards and traditional methods of
production are common among firms, centenary wineries compete with young
successful ones, and diversified firms coexist with specialized ones.
Rioja wines are divided into four categories according to the classification
provided by the Regulatory Board of DOCa Rioja, which are ordered by value added. In
the Spanish nomenclature, the first group includes mostly “garantía de origen” wines,
which have not been aged in oak casks. The next group of wines includes “crianza”
wines, which must spend at least two years at the winery before being released. The
third group comprises “reserva” wines, which must have at least three years ageing
both in barrel and bottle. Finally, “gran reserva” wines are made from the best vintages,
using only the finest red grapes; they must spend at least five years in the winery.
These four categories are proportional with a growing value added in the product, or in
other terms, with a growing willingness to pay by the consumer. These objective
categories allow to establish a vertical differentiation of the product in the Industrial
Organization sense4.
Sampling and Data Collection
In this study, our aim is to examine the motives for vertical integration in the Rioja
Designation of Origin wine industry. Hence, the first criterion in selecting the sample
was that the firm belongs to the DOCa Rioja5 and was wine-making processor6. The
second criterion was that they presented financial information to the public registries7.
Wineries that were created as cooperatives of growers were excluded of the study
since these firms cannot adopt an independent decision about its vertical integration.
The data for this study were collected through the use of a letter sent through
regular mail. We aimed to develop a questionnaire which was well adapted to the wine
industry. To do this, we first had discussions with several individuals who had a clear
4 Two wines are said to be vertically differentiated if one wine captures the whole demand when both are supplied at
the same price. One wine dominates the other and differences in willingness-to-pay for “quality” across consumers
explain why both wines are present in the market (Dos Santos Ferreira and Thisse, 1996).
5
The population was drawn from the 2007 list provided by the Regulatory Council of the Rioja Designation of
Origin.
6
Winemaking cooperatives were excluded because they don’t face the “make” or “buy” decision since their members
are usually vineyard owners, who deliver grapes to the cooperative.
7
It is a prerequisite of transparency of information that implicitly excludes micro-firms from this study
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Proceedings of European Business Research Conference
Sheraton Roma, Rome, Italy, 5 - 6 September 2013, ISBN: 978-1-922069-29-0
understanding of the activity. Based on these sources of information and on our
theoretical framework, the survey was designed to elicit information about industrial,
transactional and firm-specific attributes. Surveys were mailed to all respondents along
with a letter on university stationary from the researchers explaining the coding
systems, the purpose of the study and the confidentiality of the replies. Respondents
were offered a summary of the results to encourage their participation. Surveys were
returned directly to the researchers in pre-addressed, postage-paid envelopes provided
with the survey to emphasize the academic control of the information. One follow-up
mailing with a duplicate survey and cover letters was sent to non-respondents.
The survey was returned by 187 valid participants8, 88.2 per cent of the
population. In order to limit the influence of external shocks, the study period refers to
the past 3-year period. A comparison of responding wineries with the population of all
general wineries using the chi-square test (p=0.094) showed no statistically significant
differences between the sample and the population with regards to size using the
European Commission’s classification of small and medium-sized firms. The largest
number (68%) of wineries in the sample had less than 10 employees while 27% had
between 10 and 49 employees and 5% had more than 50 employees.
Variables Operationalisation
A total of eleven determinant variables were operationalized for the current
investigation. These measures were grouped in the three sets identified from the
literature. Transactional attributes, firm-level capabilities and product differentiation
strategy formed the three sets. We describe each of the eleven measures, by set,
below.
(i)
Measures for Transaction Attributes
For this set of determinant variables, we operationalized measures of specific
assets, small numbers, uncertainty and size.
We use items on seven-point scales anchored by “strongly disagree” and
“strongly agree” to measure some transaction cost dimensions, specificity and
uncertainty. This form of measuring presents the disadvantage of its subjectivity; it
depends on a personal evaluation. However, subjective estimations of specificity and
uncertainty have often been used in empirical studies, which is mainly due to a lack of
direct qualitative information (e.g. Anderson and Schmittlein, 1984; Anderson and
Coughlan, 1987; Anderson and Weitz, 1992). The constructs were operationalized
with a mix of original and adapted items relied on previous survey-based transaction
cost studies.
Specific assets (Hypothesis 1): The degree of specificity can be measured by the
difference between the cost of the asset and the value of its second best use
(Williamson, 1985). Asset specificity can take several forms: physical asset specificity,
human asset specificity, site specificity, dedicated assets, temporal specificity and
brand name capital. For the purpose of this study, we focus on physical asset
specificity and dedicated assets.
8
All the questionnaires returned were usable responses because we followed up missing questionnaires.
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Physical asset specificity describes the situation where physical assets are
tailored to a specific relationship and are difficult to re-deploy for other purposes
without sacrificing productive value. Many empirical studies provide support to the
basic TCE assumption that physical asset specificity is positively associated with the
decision to integrate (e.g., Klein et al., 1978; Monteverde and Teece, 1982a; Joskow,
1985; Hennart, 1988; Lieberman, 1991; Ohanian, 1994). Two complementary
measures of asset specificity were developed. The first measure is the degree of
downstream physical asset specificity, which measures the level of total fixed
investment made by the processor. A second measure, the degree of upstream
physical asset specificity, asked about the fixed investments made by the primary
producer.
Dedicated asset specificity refers to assets which are assigned for the purpose of
the current transaction only and would result in significant excess capacity if the
transaction terminated prematurely (Williamson, 1983). Less attention has been paid to
this type of specificity than to physical asset specificity. One exception is Adler et al.
(1998), who operationalized dedicated asset specificity as the time to meet the buyer’s
requirements from contract start date to product acceptance.
Applied to our study, dedicated asset specificity refers to grapes which were
grown for one particular vintner. As wine grapes are extremely perishable, the vintner
could seek to appropriate rents by taking advantage of the grower’s need to harvest
and sell his grapes in a relatively short period of time (Goodhue et al., 2003). Given
this definition, dedicated asset specificity was operationalized as the excess capacity
that a primary producer has to support if the grapes which were grown for a particular
winery are rejected by it.
All measures of transaction-specific assets are developed and scaled such that
higher scores imply higher degree of specificity in the transaction.
Small numbers (Hypothesis 2). To test for the effect of small numbers on the probability
of vertical integration, the number of existing (or available) suppliers in a given period
of time has been used traditionally as a measure of small number bargaining problems
in previous literature (e.g., Pisano, 1990; Lieberman, 1991; Leiblein and Miller, 2003).
Yet, many studies have ignored that this measure may be affected by vertical
integration decisions in prior periods. An exception is Bigelow and Argyres (2007), who
recognized that using a forward measure of existing suppliers could introduce an
endogeneity problem in their regressions, causing the coefficient estimates to be
biased. Likewise, they recognized that using a lagged measure of existing suppliers
also has disadvantages. While this measure helps with the endogeneity problem, it fails
to account for expectations about the future number of suppliers. Then, in order to limit
the influence of the year analyzed, we used one item that asked each processor how
many growers on average would be willing to contract with him. Following to Fowler
(1995), instead of asking the exact number of suppliers, seven choices were provided
in a scale such that higher scores indicate a smaller number of available suppliers. This
improves accuracy by cueing the respondent’s memory and avoids relying entirely on a
respondent’s ability to remember this number.
Environmental uncertainty (Hypothesis 3). Following to Williamson (1975), we highlight
one type of environmental uncertainty, that of environmental unpredictability. In our
activity of analysis, the high level of dependency of viticulture to exogenous conditions
such as hazardous and risky natural environment (drought, pests, flooding, insect
infestations, disease, etc) is one of the main reasons of environmental unpredictability.
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The scaling of this concept is based on one item that indicates respondents´ perception
of environmental volatility.
As we mentioned earlier, the presumption of market superiority is undisturbed
unless assets are specific to a nontrivial degree (Williamson, 1979). Following Coles
and Hesterly (1998), this condition was operationalized by means of an interaction
between a dummy variable (λ) and environmental uncertainty. This dummy variable
takes a value of 1 if the value of all items of specificity is above 1 (the minimal value of
the scale), and 0 for values of 1.
Internal uncertainty (Hypothesis 4). Difficulty of evaluating performance is referred to as
behavioral uncertainty (Anderson and Schmittlein, 1984; Anderson, 1985; John and
Weitz, 1988; McNally and Griffin, 2004). It may occur in the viticulture activity for two
reasons. First, it is difficult to assess objectively the grape quality (Oczkowski, 2001).
Second, responsibility for vineyard production may not be assignable to an individual
grower when a team of growers have worked the same vineyard. One question
adapted from Anderson and Schmittlein (1984) addressed the perceived difficulty of
measuring the results of individual growers equitably.
Size (Hypothesis 5). This has been measured with a number of different variables in
the literature, such as assets (Anderson, 1985), sales (Pisano, 1990; Leiblein and
Miller, 2003) or logarithm of capacity (Ohanian, 1994). In particular for wineries, there
are two direct indicators of a winery’s size: the number of acres owned by the winery
and the storage capacity of the winery (Benjamin and Podolny, 1999). It is used the
logarithm of the second one because the variables based on assets owned by the
winery are directly dependent upon the decision to integrate production activities
(Leiblein and Miller, 2003).
(Ii) Measures for Firm-Level Capabilities
Marketing intensity (Hypothesis 6). The relationship between advertising and
promotional expenditures and marketing communication have been found in the works
of Farris and Buzzell (1979), Balasubramanian and Kumar (1990) and Zinkhan and
Cheng (1992). Similarly to these empirical works, we use the ratio of advertising and
promotional expenditures to sales as a proxy for marketing communication intensity.
Innovation intensity (Hypothesis 7). Research and development expenditures are used
as a proxy for innovation capability in a large number of studies in the economics
literature9 (e.g., Hirschey, 1982; Hirschey and Weygandt 1985; Connolly and Hirschey
1990; Hirschey and Spencer 1992; Sougiannis 1994; Green et al., 1996; Lev and
Sougiannis 1996; Stark and Thomas 1998; Barth and Kasznik 1999; Graham and
Frankenberger, 2000). Therefore, an appropriate indicator of a firm´s innovation
capability is the intensity of its spending on research and development (measured by
research and development expenditures to sales).
Experience (Hypothesis 8). This variable refers to the extent to which a firm has skills
and capabilities for producing the good and an understanding of the underlying
technology. Following prior empirical studies (e.g., Gatignon and Anderson, 1988;
Hennart, 1991; Padmanabhan and Cho, 1996; Brouthers et al., 2003), we measure
experience as the number of years of experience in the wine-making activity.
(Iii) Measure for Product Differentiation
9
See Pakes and Griliches (1984) for an explanation of this relationship.
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Product differentiation (Hypothesis 9). In order to examine the effect of the vertical
product differentiation we measure the weight si of every category (ith) of product in
total firm sales. The corresponding categories are the previously described: Garantía
de Origen, Crianza, Reserva and Gran Reserva. A firm with a high share in the two
latter should be considered a firm focused in high willingness-to-pay products. A firm
with high shares in garantía de origen and crianza, should be considered a firm
focused in low value added products.
Following this classification, we calculate the quadratic10 shares of each type of wine in
each firm´s total sales. The variables are referenced by appending a subscript (the
name of the category) behind the name “Share”.
Dependent Variable and Methodology
In order to measure the dependent variable, the degree of vertical integration
between two stages in the production process, respondents (wine-making processors)
were directly requested to indicate the percentage of inputs (grapes) used that is
internally provided. A tobit technique was conducted to statistically relate the survey
items to the vertical integration decision. This model is preferred over OLS regression,
since the dependent variable is censored11 in the range (0% to 100% of vertical
integration).
Results and Discussion
Table 1 shows descriptive statistics and inter-correlations12 among our variables.
Although there are some significant correlations between some pairs of variables, in
whole there is no indication of major multicollinearity problems. Further evidence of
lack of multicollinearity is given by the stability of the coefficients in the estimations
across the models.
Insert Table 1
Table II gives the coefficient estimates and goodness of fit measures for the nine
hypothesized determinants of vertical integration with the Tobit estimation. An
important issue in a model is its stability. To test for this, different models were
estimated across various specifications. Model 1 includes only the variables associated
with transaction-level effects for asset specificity, ex ante small numbers bargaining
situations, environmental uncertainty interaction and measurement problems. Model II
represents the transaction cost model and adds the control variable size. In model III,
we include our firm-level measures for marketing intensity, innovation intensity and the
experience. Model IV reports the results from our full model, which includes the
transaction and capability level variables as well as our index for product differentiation.
Likelihood statistics and measures of overall model fit are showed in the bottom line of
the table. The robustness of the estimated coefficients across model specifications
10
It corresponds to the disaggregated index of diversification suggested by McVey (1972). It has the
form
s
2
i
, where si is the share of the ith product in total sales.
11
The nature of the variable dependent destroys the linearity assumption between the dependent and independent
variables so that the OLS regression is clearly inappropriate (Long, 1997).
12
The Kolmogorov-Smirnov test determined that the variables are not normally distributed. Consequently, we use
Spearman´s correlations instead of Pearson´s correlations.
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suggests that transaction costs, capabilities as well as the product differentiation
strategy influence firms´ vertical integration decisions in the wine industry (Models I to
IV). It is shown in the likelihood ratio test statistics of each model compared with those
of its predecessor, which are all significantly different from zero. Given the stability of
our results across specifications13, our discussion focuses solely on model IV.
Our results provide strong support for some of the hypotheses derived from
transaction-cost analysis. According to hypothesis 1, transaction specificity of assets
leads to integration. It has been largely corroborated with the parameters of upstream
specificity of physical assets and dedicated assets. Conversely, the downstream
specificity of physical assets is nearly insignificant. Contrary to our expectations, the
results fail to support the existence of a significant direct effect between small numbers
and integration (hypothesis 2). Hypothesis 3 is confirmed, so environmental uncertainty
is positively related to vertical integration in presence of a non-trivial degree of asset
specificity. We do not find support for the hypothesis 4 referred to the positive effect of
measurement problems on vertical integration.
Hypothesis 5 argued that firms having greater size are less likely to internalize
their input needs due to diseconomies of scale. As we expected, the result of this
variable indicates that size affect negatively firms´ vertical integration decision.
The findings in this paper are not consistent with all our hypotheses based on the
resource and capability-based view. In accordance with hypothesis 6, marketingintensive firms are more likely to choose integration for their transactions. We find weak
evidence for this hypothesis (the coefficient associated with innovation intensity has a
p-value=0.052). With respect to innovation-intensive firms, our evidence fails to support
the hypothesis 7. However, our results provide stronger support for hypothesis 8, which
implies that the experience is significantly associated with vertical integration.
Consistent with strategic management literature, hypothesis 9 predicted that
superior quality product mix will push transactions away from the market into vertical
integration. In particular, it was argued that the likelihood of market failure was most
severe in exchanges that exhibited high differentiation based on product quality. Our
results in model 4 provide partial support for this hypothesis. While the coefficients on
2
2
shareGARANTIA
DE ORIGEN and shareCRIANZA individually do not affect significantly to vertical
2
integration, the variables corresponding to the highest quality wines, shareRESERVA
and
2
shareGRAN
RESERVA support the existence of a significant direct effect between vertical
product differentiation and integration.
As a robustness check, ordered logit models14 that included eight choices for the
dependent variable15 were run to replicate the tobit models, using all variables
included in model IV. Table III reports the results of this analysis, and provides a very
similar picture from what the tobit model presents.
Insert Table Iii
13
The coefficient associated with the variable marketing communication intensity in model 4 is nearly statistically
significant (p-value=0.052).
14
The multinomial logit model is not appropriate because the independence of irrelevant alternatives assumption is
violated.
15
We established the eight options of the dependent variable used by Parmigiani (2007) in her ordered logit:
 0 %  Over 0-10 %  11-25 %  26-49 %  50-74 %  75-90 %  Over 90
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Discussion
Our results provide evidence that the combination of strategy, transactional and
firm-specific factors appears to offer a useful explanation of the firms´ vertical
integration decision in the wine-industry.
The incremental benefit from including each set of factors in the analysis can be
evaluated with the statistical significance. In this way, transactional attributes are highly
effective at explaining vertical integration decisions (Nagelkerke´s R2=0.374).
Transactional attributes have a contribution to the vertical integration choice in different
ways. Consistent with transaction cost analysis is the finding that the decision of
vertical integration is reinforced as asset specificity increases: firms integrate to avoid
problems of lock-in that may arise from large sunk investments. It is observed that
upstream physical asset specificity and dedicated asset specificity present the
appropriate sign and are statistically significant. However, downstream physical asset
specificity has a much lower significant impact on the decision to integrate these
transactions. This result is consistent with the fact that a winery’s profitability is
increasingly not limited to winemaking. Indeed, many regional winemakers diversify
their winery activities in order to develop additional income streams through a
commitment to wine and cultural tourism (Lumbreras, 2004).
The results fail, however, to support the small-number hypothesis, which is a less
central prediction of the transaction cost model. This finding is in contradiction to prior
empirical work (e.g., Levy, 1985; MacDonald, 1985; Caves and Bradburd, 1988; Martin,
1988). However, we caution that this non significant result can have at least two
explanations. One possible explanation for this is that in DOC Rioja wine industry,
there were a simply a sufficient number of suppliers available to make small number
bargaining problems a minor consideration. Another possible explanation is that our
measure of existing suppliers is a noisy measure of actual supplier availability (Bigelow
and Argyres, 2007). The insignificant effect of small numbers was also obtained by
Lieberman (1991) and Bhuyan (2005).
We also find support for Williamson’s (1985) proposition that environmental
uncertainty, in presence of a non-trivial degree of specificity, raises transaction costs
appreciably. Thus, hypothesis 3 is supported. We also performed these analyses for
the case where the dummy variable λ=1 for the values of all items of specificity above
2, and 0 otherwise. The results of the empirical analyses were not substantially
changed by altering the interaction variable in this way.
The results provide weaker support for hypothesis 4, that increased
measurement problems in the transaction leads to an increased use of vertical
integration. This result apparently contradicts other empirical papers. However, industry
singularities might explain this divergence. European wine growers and wine
processors live in small villages in which people know one another quite well through
an efficient mouth-to-mouth communication network. Hence, the contractual parties
know each other prior to lease. Some of them are family members and others are
introduced by a neighbor or relative. In such a circumstance, reputation certainly
matters and it diminishes the possible effect of internal uncertainty, because cheaters
would soon become known in the industry (Fernández, 2008).
Consistent with hypothesis 5, the size of the winery is negatively related to
vertical integration. According to transaction cost reasoning, the incentive for vertical
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integration is negated by strong diseconomies of scale, supporting that diseconomies
of scale could be a factor limiting the extent of vertical integration (Williamson, 1974).
Applying this argument to viticulture, the diseconomies of scale are generated by the
distance between the vineyard and the winery. It is known that a key aspect of
improving wine quality is control of the entire production process from vineyard planting
to the finished product. When a winery needs large quantities of grapes, their supplying
vineyards cannot all be near the winery. Hence, in large wineries with integrated
production of grapes, managers would need to spend a lot of time visiting their
vineyards.
In order to examine whether the internal pool of capabilities really add
explanatory power to our model, Nagelkerke´s R2 was compared between the model 3
and the model 2. The observed increase in Nagelkerke´s R2 was 0.085 and
demonstrates that firm-specific capabilities also increase the explanatory power of the
model. In general, the availability or the building of capabilities in the firm definitely
increases the degree of backwards vertical integration. However, research and
development expenditures are insignificant, indicating lack of support for hypothesis 7.
Similar to hypothesis 4, the discrepancies could be due to differences in the specific
characteristics to the industry in which innovation efforts in wineries appear not to affect
the grape crop.
To the contrary, hypothesis 8 relates the effect of experience on vertical
integration. This hypothesis is tested with the coefficient of the term experience. This
coefficient is positive and highly significant, what corroborates the hypothesis
proposed.
Insert Table Iii
We have finally obtained support for the hypothetical relation between a firm’s
focus in high value added products and the degree of vertical integration. This result is
consistent with the classical Edmonds´ (1923) proposition that an important motivation
for vertical integration is that “the purchaser of the high-priced automobile prefers to
buy a car which is manufactured by the company rather than simply assembled”
(p.436), suggesting a high quality level or willingness-to-pay effect associated to
vertical integration. In many manufacturing industries such proposition has become
weaker as advances in standardization and information technologies has allowed
stronger de facto integration with external suppliers. However, the proposition
conserves its validity in the food industry where such advances have been less evident.
In table IV, we summarize the hypothesis formulated above and the results
obtained.
Insert Table Iv
Finally, a global reflection about the determinants of vertical integration arises the
question about endogeneity of the explanatory variables, or the real direction of the
cause-effect relations. However, the interpretation of the results is unambiguous: a
vertical product differentiation strategy towards high willingness-to-pay products is
afforded with higher levels of vertical integration, once controlled the effects of other
known determinants for vertical integration. At least, it is true for those industries where
the control of the processes all along the value chain is important for a high quality
guaranty.
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Conclusions
Understanding the factors that determine which type of transactions are mediated
through markets and within firms has been an important subject of theoretical and
empirical work in the economics and management literature. Despite the considerable
research on determinants of vertical integration, this paper develops and tests a model
of vertical integration choice that contributes to the literature by analyzing strategies,
transactions and firms attributes. The main results indicate that transaction costs, firmlevel capabilities and differentiation strategies independently and significantly influence
firms´ vertical boundaries choices.
The results of this study are generally consistent with the existing empirical
literature on the subject. Previous studies have suggested that undertaking new stages
in the value chain is conditioned by not only transaction costs but also production cost
differences (Argyris, 1996; Jacobides and Winter, 2005; Madhok, 2002; Leiblein and
Miller, 2003). As in these studies, we found that firms integrate to reduce transaction
costs and protect strategic resources and capabilities, among other motives. Similar to
Díez-Vial (2007), we also found that transactional attributes are more relevant that
capabilities in explaining firms´ boundaries. While this result appears to contradict other
empirical papers, measures differences might explain this divergence (Walker and
Weber, 1984; Leiblein and Miller, 2003).
Along with the transaction cost and the capability-based view, the strategy
management literature appears to offer a useful explanation of the use of vertical
integration. The influence of product differentiation strategy on the vertical integration
decision is an important distinction in our model. Our study suggests that firms that
seek to have highly differentiated products are associated with a greater likelihood of
internalizing production.
The analysis presented here leaves unanswered some interesting questions
about governance mode choice. Our study focused on vertical integration decisions in
the wine industry. Thus, conclusions and inferences about the results may be limited to
this setting and may not address vertical integration choice in other industries.
However, we believe many of the factors that are associated with firm boundaries in
the current study can be found in other settings, particularly in differentiated-product
industries with low – standardized supplies.
Another potential complementary perspective to explore the determinants of
vertical integration decision could be the economics of property rights (e.g. Coase,
1988; Alchian, 1977; Demsetz, 1988; Eggertson, 1990; Barzel, 1997). For this
approach, property rights to resource attributes consist of the rights to use, consumer,
obtain income from, and alienate these attributes (Foss and Foss, 2001). As a
consequence, property rights are important in viticulture because a vineyard owner’s
ability to create, appropriate, and sustain value from it partly depends of the property
rights that he or she holds and how well they are protected.
A cross-sectional research design was chosen for this paper in order to provide
comparability with extent research on the vertical boundaries of the firm (e.g.
Monteverde and Teece, 1982a, 1982b; Walker and Weber, 1984, Masten, 1984; Poppo
and Zenger, 1998). The stability of the relationships between attributes of a given
transaction, relevant capabilities, and governance decisions over time remains an
untested area deserving of attention. In the wine industry, it would have been helpful if
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we had had data on the wineries´ experience in previous growers-wineries
relationships. With this information, we could analyse how this factor reduces
negotiation costs and allows the winery to develop useful capabilities for choosing and
governing new relationships.
While this study emphasizes insights derived from different views in the
management and economics literature on vertical integration, interactions among
perspectives are not considered. Given that we found some correlation between
explicative factors, it would be interesting in future research to test how they influence
each other.
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Tables and Figures
20
Proceedings of European Business Research Conference
Sheraton Roma, Rome, Italy, 5 - 6 September 2013, ISBN: 978-1-922069-29-0
Table I. Descriptive statistics and Spearman´s correlationsψ
Variables
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
1
1
2
0.308**
1
3
0.288**
0.246**
1
4
0.393**
0.322**
0.103
1
5
0.300**
0.122
0.071
0.204**
1
6
0.474**
0.298**
0.035
0.302**
0.276**
1
7
0.316**
0.134
0.262**
0.236**
0.216**
0.277**
1
8
-0.376**
-0.079
-0.020
-0.188*
-0.161*
-0.272**
-0.091
1
9
0.133
0.096
-0.007
-0.087
0.132
0.176*
0.085
0.112
10
0.203**
-0.005
0.122
-0.019
0.124
0.077
0.093
0.182*
0.249**
11
0.199**
0.015
0.116
0.056
0.029
-0.019
0.091
0.105
0.087
0.177*
1
12
-0.110
-0.012
-0.049
-0.088
-0.092
0.085
-0.005
-0.220**
-0.240**
-0.283**
-0.040
1
13
-0.238**
-0.003
-0.070
0.072
-0.001
-0.068
-0.150*
0.211**
0.120
-0.101
-0.069
-0.326*
1
14
0.079
-0.059
0.041
0.054
0.042
-0.113
0.026
0.264**
0.258**
0.301**
0.167*
-0.599**
0.017
1
15
0.073
0.065
0.039
-0.088
0.007
0.012
0.061
0.281**
0.216**
0.318**
0.200**
-0.440**
-0.163*
0.304**
1
Mean
56.283
4.813
4.546
3.904
3.385
4.679
3.588
3.931
1.044
2097.56
2028.43
1180.88
437.02
σ
39.750
2.041
1.847
2.092
1.808
1.794
1.883
1.340
4.778
2.455
45.288
3014.95
2343.95
2283.50
1786.35
[1,7]
[1,7]
[1,7]
[1,7]
[1,7]
[1,7]
[11,19]
[0-25]
[0-20]
[1,406]
[0, 10000]
[0, 10000]
[0, 10000]
[0, 10000]
Range
[0-100]
14.132
1
1
34.685
1. Degree of VI 2.Downstream physical specific assets 3.Upstream physical specific assets 4.Dedicated specific assets 5.Small numbers 6.Environmental uncertainty 7.Internal uncertainty
2
2
2
2
8.Size 9.Marketing communication intensity 10. Innovation intensity 11.Experience 12. ShareGARANTIA
13. ShareCRIANZA
14. ShareRESERVA
15. ShareGRAN
RESERVA
DE ORIGEN
ψ
N=187
Levels of significance: * p<0.05; ** p<0.01
21
Proceedings of European Business Research Conference
Sheraton Roma, Rome, Italy, 5 - 6 September 2013, ISBN: 978-1-922069-29-0
Table II. Estimates using Tobit for censured data at two extremes (0, 100)
Variables
Estimated parameters coefficients (standard errors)
Model 1
Model 2
Model 3
Model 4
Downstream physical specific assets
2.592 (2.177)
3.266 (2.079)
3.342 (1.886)
2.744 (1.805)
Upstream physical specific assets
7.194 (2.360) **
6.741 (2.247)**
5.259 (2.039)*
4.620 (1.946)*
Dedicated specific assets
5.869 (2.137) **
5.315 (2.036)*
5.533 (1.883)**
6.234 (1.857)**
Small numbers
4.123 (2.373)
3.033 (2.278)
1.714 )2.084)
1.635 (2.024)
11.787 (2.579)**
10.296 (2.452)**
8.165 (2.252)**
8.975 (2.168)**
4.736 (2.395)
4.530 (2.292)
3.752 (2.098)
2.305 (2.079)
-11.351 (2.888)**
-12.921 (2.671)**
-11.426 (2.731)**
λ*Environmental uncertainty
Internal uncertainty
Size
Marketing communication intensity
2.124 (0.941)*
1.931 (0.985)
Innovation intensity
2.875 (1.589)
2.008 (1.550)
Experience
0.422 (0.100)**
0.370 (0.097)**
2
ShareGARANTIA
DE ORIGEN
0.002 (0.002)
2
CRIANZA
0.000 (0.002)
2
RESERVA
Share
0.004 (0.002)*
2
ShareGRAN
RESERVA
0.010 (0.004)*
Share
Cragg-Uhler (Nagelkerke) R2
Log Likelihood
Chi-square statistic
0.374
-610.994
0.0000
0.423
0.508
0.546
-603.294
-588.435
-581.029
0.0000
0.0000
0.0000
Notes:
ψ
N=187 for all models
Levels of significance: * p<0.05; ** p<0.01
Parameter estimates for constants are omitted.
λ It represents the non-trivial degree of specificity
22
Proceedings of European Business Research Conference
Sheraton Roma, Rome, Italy, 5 - 6 September 2013, ISBN: 978-1-922069-29-0
Table III. Ordered logit model
Estimated parameters
coefficients (standard errors)
Variables
Model 1
Downstream physical specific assets
0.151 (0.079)
Upstream physical specific assets
0.175 (0.083)*
Dedicated specific assets
0.251 (0.080)**
Small numbers
0.057 (0.088)
λ*Environmental uncertainty
0.372 (0.094)**
Internal uncertainty
0.099 (0.087)
Size
-0.515 (0.121)**
Marketing communication intensity
0.085 (0.043)*
Innovation intensity
0.079 (0.076)
Experience
0.014 (0.004)**
2
GARANTIA DE ORIGEN
Share
0.000 (0.000)
2
ShareCRIANZA
0.000 (0.000)
2
ShareRESERVA
0.000 (0.000)
2
ShareGRAN
RESERVA
0.000 (0.000)*
Cragg-Uhler (Nagelkerke) R2
Log Likelihood
0.546
-281.839
Chi-square statistic
0.0000
Table IV: Summary of main results
Theoretical framework
Transaction Cost
Economics
Resource and
Capabilities Theory
Strategy Management
Vertical integration hypotheses
Expected effect
Results
H1: Asset specificity
+
Corroborated
H2: Small numbers
+
Failed
H3: λEnvironmental uncertainty
+
Corroborated
H4: Internal uncertainty
+
Failed
H5: Size
-
Corroborated
H6: Marketing intensity
+
Weakly corroborated
H7: Innovation intensity
+
Failed
H8: Experience
+
Corroborated
H9: Product differentiation strategy
+
Corroborated
λ It represents the non-trivial degree of specificity
23
Proceedings of European Business Research Conference
Sheraton Roma, Rome, Italy, 5 - 6 September 2013, ISBN: 978-1-922069-29-0
Figure 1. A model of vertical integration decisions incorporating transactional, firm-level and
industrial attributes.
Small numbers
Asset specificity
(+)
Transactional
attributes
(+)
(+)
(+)
Minimization of
transaction costs
Environmental uncertainty
Internal uncertainty
(+)
(-)
Size
Marketing intensity
Innovation intensity
Experience
(+)
Diseconomies
of scale
Firm attributes
(+)
(+)
Degree of vertical
integration
Capability
development and
path dependence
Strategy attributes
Product differentiation
(+)
(+)
(+)
Ability to control
input quality
24