Technological Change and Evolving Firm Boundaries

Subject: Strategic Management
Pages: 40
Words: 11780
Reading time:
42 min
Study level: PhD

Abstract

Recently there has been enhanced interest in the belief that in complying with the demand of technological changes, firms will perform much better if they vertically integrate new technologies. Theorists also claim that firms that continue to vertically integrate into the old technologies will not perform well and lag behind their competitors. The theory supports the belief that efficient boundaries of a firm are dynamic which can be substantiated by building upon transaction cost economics and the knowledge-based theory of the firm. In stressing the role of technological change, economists have used the concept of deconstruction, recent business paradigms, and altering market concepts in explaining the vertical integration of firms. This approach provides new perceptions and this paper has revealed how theoretical foundations broaden its appeal by including the knowledge base from the dynamic capability approaches and of progressive economics. The paper demonstrates how technological change in terms of technological opportunity, new knowledge, transfer of knowledge and other appropriate circumstances influence the firm’s decisions to alter the value chains, choice of business models, and the progression of the market conditions. Such circumstances result in new business models that are nonspecific and based on this analysis a strategic framework has been developed that will assist firms in picking the most attractive options in the industry’s value chain.

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Introduction

The vertical boundaries of the firm are a major area of research in the literature about strategic management. Having been faced with intense rivalry with competitors, several firms that were vertically integrated, opted to outsource many of their activities to outside suppliers. The theoretical basis was made possible by the market-based viewpoints of strategy, mainly from the frameworks of value chains as modeled by Porter (1996). This strategy focuses on the bargaining powers of suppliers and their ability to exploit activities of internal synergy, uncertainty in markets, and the firm’s vertical boundary. During the early 1990s, transactional cost economics had become the dominating concept in resolving the problems regarding firm boundaries. Although the uncertainty and occurrence of dealings are thought to be meaningful, the specificity of the capital and the value chains is of much relevance in the area of vertical integration (Williamson 1989). The specificity of assets results in a lack of symmetry in the bargaining power of the concerned forms which impacts the benefits available for investing in relationship-specific resources. If the resources are definite, vertical integration will ensure the optimum investment into the resources thus creating an effective firm in the given value chain.

Although transaction cost economics and the theory of incomplete contracts had influenced the strategic literature on management to some extent, it was criticized for being a bad practice (Ghoshal, Moran 1996). Some critics have pointed that transaction cost economics is fundamentally constant and restricts its application to matured firms. It lacks a convincing argument to explain competitive advantages and does not appeal to the basic issue of strategic management. The resource-based approach of strategies enables another concept towards vertical integration by focusing upon the significance of strategic resources for the boundary of firms. Long-term competitive advantage is achieved with the use of internal control of resources that have immense value, are not easily available, difficult to copy, and difficult to replace (Barney, 1991). Most of the established firms focus their attempts on using such strategic resources and the resources that are available internally, influence the vertical boundary of the firm. Additionally, to protect the firm’s strategic resources and competency, protective belts of other resources are utilized to protect the spillover of knowledge to suppliers (Hamel, 1991).

Although such strategies throw light on the question of vertical integration several issues remain unresolved. While innovation is thought of as being a major element that influences the vertical boundaries of the firm, it is mostly an afterthought in using such approaches. Further, the decision to outsource is viewed more like a scale-down of the firm’s actions to achieve short-term profit, but the implication for the long-term growth of the firm is mostly not addressed. The outlined approaches in this regard do not take care of the effect of vertical integration on the market structures and industry dynamics by emphasizing the analysis of individual firms. Thus they are viewed as failing in capturing the broader impacts of vertical integration for the firm’s strategies, market entries, and competition. The issues of innovation, market structures, and corporate growth are important factors in the study of technological change and evolving firm boundaries. According to Teece (1986),

“Innovation is characterized by technological interrelatedness between various subsystems. Linkages to other technologies, complementary assets, and users must be maintained if innovation is to be successful. If recognizable organizational subunits such as R&D, manufacturing, and marketing exist, they must be in close and continuous communication and engage in mutual adaptation if innovation in commercially relevant products and processes is to have a chance of succeeding. Moreover, successful commercial innovation usually requires quick decision making and close coupling and coordination among research, development, manufacturing, sales, and service. Put differently, organizational capacities must exist to enable these activities to be closely coordinated and to occur with dispatch” (Teece 1986).

The ability of firms to create and exploit technological innovations is a vital element in the competitive environment in different industries. The research and development capability of firms is normally assumed as being a crucial determinant of such capabilities. Although R&D has conventionally been a significant means to enhance technical knowledge for firms, there are other sources also. Firms have the choice to make use of the R&D abilities of their competitors, suppliers, and other firms by way of mutual agreements as joint ventures, licenses, and R&D collaborations. Several experiential studies have resulted in the documentation of important differences amongst firms and industries in terms of the extent to which firms can make use of R&D services from external sources instead of relying only on in-house facilities. According to Schilling et al (2002):

“Licensing represents a market contracting option for technology sourcing. Licensing occurs when a sourcing firm purchases the rights to another organization’s patents or technology for a lump sum payment and royalties. A formal contract between the firms specifies the terms of the arrangement. Licensing provides the sourcing firm with somewhat limited control over the technology (compared to an acquisition) because the rights to the technology may be limited by the contract, and because the firm does not control the human capital that created the technology. Moreover, the mutual commitment between the two firms is minimal because the source of the technology has a low stake in the success of the sourcing firm” (Schilling et al, 2002).

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A dynamic approach has been adopted in this paper to study the theories of vertical boundaries of firms and their influence on the structure of the industry. Attempts have been made to scrutinize the strategic options with firms during the process of deconstruction.

Literature Review

Transaction Cost Argument

The question of when a firm should integrate vertically backward is a crucial strategic issue since the relevant transactions cost argument in economics pertains to whether the firm is integrating vertically for producing its inputs or other inputs that are germane to its objectives. The question also arises about the occurrence of interactions amongst the firms and suppliers and the extent to which the supplier is opportunistic (Williamson, 1989). The large-scale availability of new information and communication technology and the enhanced competition in several industrial sectors renewed the discussions regarding the optimum vertical boundaries of firms and their efficient placement in the value chains. The unbundling of the conventional value chains results in the dismantling of the vertically integrated Chandelerian firms (Chandler,1990) as the central organization model of a typically large firm (Pavitt, 2003). Complex information enabled the provision of the economic bonding amongst vertically integrated value chains and the high cost of shifting the valuable information to suppliers, distribution agencies and clients made vertical integration possible since contracting in such markets was not effective in transferring the information.

According to Mahanke (2000), “outsourcing in an evolutionary process perspective is conceptually different from vertical integration (the main concern of transaction costs theory and the property right approach) or diversification (a major concern of the resource-based view). Both concern processes through which a firm expands the scope of its activities. In the context of diversification the boundaries of the corporation can be understood in terms of learning, path dependencies, technological opportunities, the selection environment, and the firm’s position in complementary assets. If this argument is correct, then boundary decisions to expand the scope of the firm, once taken, might not be easily reversible (as assumed in transaction cost, and property right theory) – they are conceptually different from outsourcing” (Mahanke, 2000).

The increasing use of information and communication technology made it convenient to share the information beyond a firm’s boundaries thus undermining the foregoing logic as also enabling the sourcing of additional activities to external suppliers. Evans (1998) has held that such patterns permit vertically integrated firms to improve their abilities in markets by the process of de-averaging internal initiatives. A vertically integrated firm can reap competitive advantages by way of activities carried out in an integrated value chain although superior performance is not guaranteed in all its actions. This procedure results in the averaging of corporate profits since vertical integration makes weak performing internal actions to be subsidized thus reducing the combined efficiency of the firm. Magnani (1998) has argued that:

“the pressure of the world economy has forced firms to focus on their distinctive resource profile – those competencies and capabilities that are unique, firm specific, valuable to costumers, non substitutable and difficult to imitate. The resulting emphasis on innovation, especially in terms of new resource combinations, has certainly contributed to wholesale changes in the internal organization of the firm” (Magnani, 1998).

Vertical Integration

By outsourcing weak performing activities the firm can enhance its profitability and strengthen its market position by stressing actions that result in competitive advantage. The de-averaging process enables a strong purpose for vertically integrated firms to deconstruct and companies which focus on single layers in the value chain of the industry facilitate this process. According to Edelman (1999), specialized layer players claim superior positions in exploiting the opportunities for growth in specific parts of the value chains as compared to vertically integrated firms. The averaging of the production actions means that all development opportunities in the value chains are not adhered to which makes vertical integrators suffer from disadvantages. As per this approach, the layer players are the major strengths of vertical disintegration since they enhance competition on vertical integrators thus forcing them to deconstruct in avoiding risking the loss of their competitive positions in the value chains. Thus the vertical organization of the value chain is changed in having important implications for the market structures. Barriers to entry are reduced, processes and product innovations are accelerated and competition is intensified.

The vertical integration of a firm’s value chain results in the creation of problems in coordinating the different actions of layer players and their integration into a coherent basis. A notable example in this regard is Nike which is known to focus on product designs and in-house marketing while depending upon layer players for other roles such as manufacturing. Such business models are created around core resources such as easy access to channels of distribution and a strong brand image. They also focus on creating strong systems integration capability in being able to effectively coordinate the layers to have a stronger position than vertical integrators. Navigation amongst deconstructed initiatives is another option whereby orientation for clients is offered in deconstructed industries. If customers are faced with several suppliers the navigator will take action in reducing the costs by offering particular selections based on the customers’ specific needs.

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Vertical integration enables strategic options for new companies and creates an impact on the markets and in the reasonable positioning of such entrants. But the theoretical framework is not very well-grounded from the perspective of management theories and relies on different schools of thought without forming a concrete basis for the theoretical underpinning. Although communication technology is a significant force the entire explanations in this regard are not very convincing. As observed by Chandler (1990), the developments in communication and information technology in the early part of the twentieth century led to the creation of vertically integrated companies whereby large companies could be managed effectively. This results in more vertical disintegration of the firm instead of better management of the vertically integrated firms. Chandler (1990) also argued that vertical integration occurs since it enables the organizational capability to be exploited in not being shifted away from the firm’s boundaries. Such organizational abilities result from the learning processes in the organizational setup and comprise of implicit knowledge. Theorists have held that nonverbal characteristics define implicit knowledge which cannot be theoretical but has to be achieved by the process of learning by doing.

Innovations do impact the vertical boundaries of firms, business models, and the structure of industries, although the theoretical frameworks need to be more elaborated. The dynamic capability approach renders a result-oriented departure since it emphasizes the innovations, capability, and market dynamics of the firm (Teece, Pisan &, Shuen, 1997). In this context, the different knowledge structures form a consistent basis for varied innovations. Thereafter, new products face the market tests in being viewed from the resource-based perspective and the main task of the firms becomes to make effective use of their current resources and capability in trying to develop additional assets to succeed in the future. However considerable time can be taken in the creation of new assets by the processes of investing and organizational learning. Therefore it is evident that the behavior of the firm is dependent on the path that it takes since it faces constraints in terms of the existing resources. Because firms have varied resources which imply different opportunities for innovation and imitation, they adopt different strategies for the future (Teece, Pisano & Shuen, 1997). The exploitation of the current resources of firms is coordinated by the dynamic capabilities as also by the exploration of new and profitable resources. According to Schilling et al (2002),

“Barriers to Imitation and Information Costs. Barriers to imitation (such as tacitness or social complexity) pose information transmission problems between the source and sourcing firms, creating information asymmetry and information costs. The technological know-how that is tacit may be difficult to measure and even harder to transfer. The more difficult it is to determine the quality of a good or service, the more difficult and expensive it is to utilize market mechanisms for its exchange.

In such a circumstance, information transmission constraints may make it virtually impossible to transfer the technological know-how through an arms-length contract. The conclusion is that under these conditions, common ownership and managerial directives will be more efficient than market contracts, which are likely to be subject to opportunism” (Schilling et al, 2002).

Creative Destruction and Innovation

Under such conditions, innovation encourages and enhances the process of competition and well-established companies have to consistently confront new threats in sustaining the value of their assets. This process has been termed creative destruction and firms have to decide amongst different capabilities and resources to survive amidst such creative destruction. Teece (1986) has pointed that innovation reduces the value of technological assets and leaves the future value of complementary resources unaffected. He also revealed that complementary resources enhance the worth of a company’s technological innovations. He has held that “The formal and informal structures of firms and their external linkages have an important bearing on the rate and direction of innovation. This paper explores the properties of different types of firms with respect to the generation of new technology. Various archetypes are recognized and an effort is made to match organization structure to the type of innovation. The framework is relevant to technology and competition policy as it broadens the framework economists use to identify environments that assist innovation” (Teece 1986).

A firm’s complementary resources comprise marketing capability, knowledge of regulatory practices, and customer base. Such complementary resources do not get impacted by technological innovation and protect the firm from the forces of creative destruction. The firm’s resource profile is inclusive of complimentary resources which enable it to take advantage of negating the early mover benefits taken by technological personnel. Hence theorists believe that firms benefit from vertically integrating the complementary downstream resources.

The dynamic approach in this regard has been further elaborated in terms of the normative and explanatory powers emanating from research done in the area of sectoral innovation systems and their technical regimes (Malerba, 2002). This approach has provided a basis for the study of the factors that lead to the development and diffusion of innovative practices in industries. Malerba (2002) has defined a sectoral system of innovation as “A sectoral system of innovation and production is a set of new and established products for specific uses and the set of agents carrying out market and non-market interactions for the creation, production and sale of those products. A sectoral system has a knowledge base, technologies, input and an existing, emergent and potential demand” (Malerba, 2002). Technological opportunity, the degree of cumulativeness of technical know-how, the ability to transfer required knowledge, and the suitability conditions form the basis of technical regimes.

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Technological avenues impact the efforts made towards innovation in sectoral systems. Rapid innovations take place in an environment of technological opportunities that attain significance from the constant development of new procedures and products. Wider opportunities in technology permit the employment of new innovators as and when established firms do not exploit existing opportunities. Such opportunities are lost over time with the maturing and refinement of techniques (Dosi, 1982). The course which the innovations take is dependent on how firms make use of the technical opportunities. Under conditions of demand-pull innovations, the emerging choice of buyers directly impacts the innovative strategy of firms and under conditions of technology push innovation buyers are moved by the technological possibility of new techniques which makes firms strive towards creating demand for the new products.

Technological resources are a strong determinant of the technical opportunities that can be tapped by firms. A firm needs to be in possession and to have access to the required technical knowledge and ability to exploit the innovation opportunities. According to Langlois (1995), firms within similar sectoral systems portray different sets of innovative behavior due to the firm-specific variations in the technical competencies. The cumulative aspect determines the extent to which new knowledge is gained and how it builds the technical assets of the firm. Additional innovations combine with the current assets and strengthen the competitiveness of the concerned firms. This kind of innovation has been termed by Tushman and Anderson (1986) as competence-enhancing. In contrast, innovations that are competence-destroying present a low level of knowledge cumulativeness because new competency is required to make use of the prevailing opportunity and the current technological assets tend to move towards becoming obsolete gradually.

Technical Opportunities and Innovation

Technological opportunities provide choices for the firm’s growth by way of the creation of new products and procedures. Such innovations are not possible without strenuous efforts and result from the search process that requires the provision of technical and other resources by the company in exploring and exploiting the available technical opportunities. Vertical integrators have to face broadly spread technical prospects in the value chain of the industry that is facing challenges to select the most appropriate avenues for the allocation of their limited internal resources. Firms that make attempts to use the opportunity available in the value chains run into complications relating to averaging which is outlined by the relevant literature. Rather than focus on making efforts in few specific areas, resources are spread by the firm over varied opportunities thus risking failure in allocating the required resources for all opportunities. Consequently, the firm makes efforts but not in the right direction thereby weakening itself in the competition in all aspects of the value chains, which further results in limited options for growth in the future. This issue has been highlighted by Porter (1996) in arguing that the basic purpose of any strategy is to choose what a firm does not want to do. Vertical integration allows options in offering escape routes from such a growth trap.

When the knowledge levels are low in parts of the industry’s value chain, the firm’s technical resources become outdated and could threaten the competitive advantages of its vertical integrators. Therefore the technical changes tend to destroy the competitive advantages of the firm (Tushman and Anderson 1986). The firms could fail for several reasons in perceiving the adaptability needs of their resource bases and thus become tied up with older techniques. If the firms do recognize that the techniques have become obsolete, they can decide to avoid investing in the new technology if the cost of investing in the opportunities is high and then the firm has options for development in other areas. New incumbents can have the attacking advantage in being better placed to compete with other new entrants. By adopting the layer player strategy incumbents can stress activities within the value chains where the prevailing technical possibilities are outdated. The vertical integrators are thus deconstructed in losing their competitive advantage that had accrued from the now replaced technical resources. Such actions enable the creation of new growth avenues in the industry which can be exploited by layer players.

Technological changes do not always impact the complimentary resource base of incumbents and an altered corporate strategy becomes a reasonable choice for vertical integrators (Teece, 1988). Rather than develop technology from within, the firm focuses on integrating inputs and components about layer players into consistent product arrangements as also as marketing them to customers. Since the integration tasks are crucial for firms, this business concept is also termed as a system integrator in theoretical terms (Brusoni, Prencipe and Pavitt 2001). The competitive advantages in this regard do not stem from their technical advantages but originate from the resources such as distribution channels, brand image, and client lists which assist firms in enhancing value to the integrated production systems.

A significant prerequisite for this model as also a means to sustain competitive advantages is the development of the capability of systems integration. Rather than build strongly into technical resources the firms require to overlap technical knowledge along with the layer players. Overlapping experience assists firms in understanding the technical advancements in different areas of the value chain in the industry and to decide the most attractive layer players, as also to integrate the inputs of layer players into a rational whole (Bruson and, Prencipe 2001). As observed by Edelman (1999), the overlapping knowledge of the firm results in the capability for integrating systems in allowing firms to devise the perfect specification for the product and then collaborate with suppliers to achieve the given specifications. Such a business model opens up new opportunities for business development if pursued in the right spirit since the previous vertical integrator emphasizes the firm’s core resources and complementary assets. The investments in technical resources are correspondingly scaled back to preserve just the capability of systems integration.

A taxonomy was introduced by Nelson (1987) in analyzing the knowledge transferability amongst firms and individuals. He identified eight diverse pairs of knowledge traits:

  • articulable or implicit
  • simple or complex
  • articulated or non-articulated
  • teachable or non-teachable
  • observable or unobservable
  • system-independent or system-dependent
  • context-independent versus context-dependent
  • mono-disciplinary or trans-disciplinary

The first part of the pairs is indicative of the knowledge form that enables the easy transfer of knowledge through the firm’s boundaries and the second part appears to reduce the transferability of knowledge. Vertical integration results if the relevant knowledge is difficult to transfer through the organizational boundaries implying the necessity of internal creation and application of knowledge. In the same context, theorists hold that unambiguous knowledge has to necessarily undergo vertical integration since internal dialogues reduce the transfer cost of complex knowledge. Information and communication technology has considerably reduced the cost of information transfer by way of the standard interfaces and protocols in communication thus making the process quite attractive. It has been concluded regarding appropriability by Teece (1986), that:

“Under many legal systems, the ownership rights associated with technical know-how are often ambiguous, do not always permit rewards that match contribution vary in the degree of exclusion they permit (often according to the innate patentability or copyrightability of the object or subject matter) and are temporary. Technical information is a fugitive resource, with limited property rights. Accordingly, investment in innovative activity may not necessarily yield property which can be reserved for the exclusive use of the innovator. But the activity may nevertheless still be valuable enough to attract some investment, depending in part on other institutional arrangements to be examined later. The degree to which new products and processes are protectable under intellectual property law will henceforth be referred to as the intellectual property regime. For expositional simplicity, regimes will be classified as strong if patents and copyrights are effective, and weak otherwise. Clearly, the industrial world does not readily bifurcate, and there exists a continuum of appropriability regimes” (Teece, 1986).

It has been concluded by Kogut and Zander (1992) that firms become effective in transferring complex and implicit knowledge. The transferability of implicit knowledge can be enhanced if it is incorporated into product elements. As it happens in communication protocol within information and communication technology, product elements provide a basis for the standard interface amongst different components. A company planning to utilize product elements must be aware of the interface specifications while it is not required to be aware of how the product element itself is manufactured. The processes of creating and using product elements, therefore, imply different knowledge criteria. The main aspect pertains to the fact that the entity using the module can use the inherent knowledge base of the module in question and is not required to possess the relevant technological assets in doing so.

In such settings, system integration is considered a prerequisite for the business model since the firm establishes the interface in enabling the integration of varied components. Additionally, layer players have to prepare in supplying the product modules. But the product modularity results from the integration process and not from the commencing points. In doing so, coordination problems arise amongst the actors in the process of integration. Modules are developed by the layer players with the onset of the interface existence and vertical integrators are deconstructed with the availability of the modules. According to Sanchez and Mahoney (1996), vertical integrators that have intentions of accelerating product innovation by utilizing knowledge that is more specialized and dispersed, play a crucial role in resolving the issues by establishing interfaces that make layer players surface with product modules. This is in contrast with the two preconditions mentioned above whereby layer players encourage integration by imposing pressure on vertical integrators.

Vertical integration and product modularity provide advantages to the individual vertical integrators, but it entails a price for all firms in the industry. Industry structure is altered by the product modules due to lowered entry barriers thus resulting in strong competition and extra pressure on all firms. The threat to firms is enhanced when the interface is nonproprietary and available for all competing firms. Therefore, such firms should make attempts in keeping the main interfaces proprietary in maintaining their potential competitive advantages.

The conditions of appropriability impact the incentive for vertical disintegration. Literature conclusively establishes that low levels of appropriability in innovation will foster vertical integration. The theory of incomplete contracts and transaction cost economics emphasize that relation-specific resources are important in creating situations whereby contracting parties are held up, thus reducing its capability in acquiring innovative rents. Resource-based views argue that vertical integration prevents knowledge from spilling over by holding the crucial knowledge within the firms. In such cases, the vertical boundary of the firm comprises a firewall to protect the knowledge from transferring because it is not required to be shared with external suppliers. Therefore low conditions of appropriability can considerably reduce vertical integration and high appropriability conditions can encourage vertical integration. Langlois (1988) has observed regarding the theoretical aspects of the concept that:

“Almost all modern economic theories of vertical integration are transaction cost explanations. We can imagine production as taking place in various stages. Considering production costs alone tells us nothing about whether each stage is likely to be a separate firm or whether some stages are likely to be jointly owned.6 Indeed, if there were no costs but production costs, we would expect the least possible vertical integration: every stage would be its own firm, and each thus could take best advantage of the particular production economies open to it. Production would be fully decentralized, and all coordination would be a matter of price-mediated spot transaction. However, there is a cost of using the price mechanism in this way. There are other costs – transaction costs – in addition to production costs; and it is these transaction costs that determine the extent of internal organization. The level of vertical integration we observe in the economy largely reflects a minimum of the sum of production and transaction costs”(Langlois, 1988).

Institutional Factors

Although institutional factors influence the appropriability condition prevailing in a given industry, they have to be impacted by the firm’s strategic decisions. Complementary assets have a major role in enhancing the appropriability strength of firms. When crucially important complementary resources are controlled, firms can improve their bargaining power with external suppliers and make the integration process more consistent with the systems. Similarly, when unprotected technical knowledge is grouped with complementary inputs, layer players can benefit from long-term competitive advantages regarding customers and also safeguard their intellectual property rights.

It is now possible to position the articulated and refined versions of the theory clearly in the following figure which illustrates the dimensions that have a bearing on the decision-making process:

Extent of the Market

The theory is elaborated in the context of an internal organization when economic changes happen for the better in distinguishing between the impact of change and the impact of the extent to which the markets are covered. This portrayal lays the basis for the appropriability and entrepreneurial variations of the theory.

If firms can comply with the given conditions of technological regimes they can deconstruct with the availability of technical opportunities as and when they are dispersed vertically. When cumulative technical knowledge levels are low, knowledge can be gainfully transferred in the relevant areas whereby appropriability conditions are reflective of the industry characteristics. Stronger vertical integration results when technical opportunities are concentrated vertically, cumulativeness levels are strong and transferability is weak. Moreover, technical opportunity and the ability to transfer are of much significance for vertical integration. Low levels of cumulative knowledge are a threat to the firm’s position and should be capable of dealing with the threats until the technical opportunities are strongly focused in the value chains in permitting the emphasis of the threatening processes. If complementary resources are controlled by the firms, they will succeed in being technical late starters. Organizations can change and make the appropriability factors stronger by making a timely investment in complementary resources. Such steps improve the chances of vertical integration but they do not substantiate the fast and sudden transformation of the industry. In essence, the firms require something more fundamental in the form of dispersed technical prospects and a larger ability to transfer since such factors impact the markets and firms in a given industry.

Case of Mobile Companies

A case in point in being a classic example of vertically integrated industries is of the mobile phone industry during the later years of the 1990s when large vertically integrated companies such as Nokia and Motorola dominated the markets in America and Europe respectively. Such vertical integrators exercised control over the designing, production, and marketing of mobile handsets as also as the infrastructure of the business. During the recent past, vertical integration has comparatively declined and the number of mobile phones manufactured by layer players has increased from just a few to an increasing number. The resource base has been widened by some layer players from production to designing in supplying custom-made mobile phones to network companies and new cell phone manufacturers. This has led to lesser barriers to entry enabling an exodus into the industry by new companies.

Layer players are now offering diverse modules about cell phone functions such as microchips and radio modules which enhance the ability to transfer technical knowledge. Users of technology do not require further knowledge in building these products and only aim at imbibing the capability to integrate systems. These two patterns have together adversely impacted the technological leadership of incumbent firms. Additionally, with the innovations in the functionality of mobile phones the value chain was enhanced which increased the demand for the product components since vertical integrating could not cope with the dispersion of advancement in techniques. The previously dominant vertical integrators such as Sony Ericson opted to go for orchestrator strategies by focusing on designing and manufacturing only a small percentage of technically complicated cell phones. Vertical integration was given up by Qualcomm in favor of layer player strategies and the firm built its business models based on licensing of complex technology such as CDMA. Recently, aggressive entrants such as Microsoft have established customized versions of pocket PCs as the dominating crossing point for operating systems.

Challenges for vertically integrated firms

The capability of firms to decide about vertical boundaries in terms of the kind of layers to organize is dependent on the competitive positioning of the firms in the specific layer and the external technical regimes and industry structures. Thus a firm has to consider internal and external issues irrespective of the type of business models it has chosen and all firms in such industries have to meet the strategic requirements of the vertical boundaries. The vertically integrating firm has to cope with challenges about the activities to integrate and the layer players have to decide about the divisions of the value chains they wish to focus on.

In keeping with the resource-based viewpoint of strategies and the dynamic capability options, internal issues influence the firm’s positions regarding its ultimate sources of competitive advantage. Resource positions of firms indicate if they hold the required technical and complementary assets which enable the achievement of sustained competitive advantage within the layers. Where technical changes enhance competence levels and the accumulation of knowledge is higher, the resource positions are taken to be having considerable strength. Similarly, when firms can develop additional resources in layers faster or at a lower cost as compared to their competitors, their resource positions are robust in gaining competitive advantages. According to Cohen and Levinthal (1990), this is possible due to larger levels of specialization and better absorption capacity which assists the firm to grasp faster than competing firms. When the resource positions are weak, the opposite is true and the firm can own only resources that are lesser in value and are easily duplicated while the cumulative knowledge levels are low. Firms with robust resource positions can make the provisions of vertical layers more attractive while the weaker resource positions imply that alternatives have to be found.

Williamson (1985) has suggested that “three transaction characteristics are critical: frequency, uncertainty, and most especially, asset specificity (as measured by the foregone economic benefits of discontinuing a relationship). Each characteristic is claimed to be positively related to the adoption of internal governance. The basic logic is that higher levels of uncertainty and higher degrees of asset specificity, particularly when they occur in combination, result in a more complex contracting environment and a greater need for adjustments to be made after the relationship has begun and commitments have been made. A hierarchical relationship, in which one party has formal control over both sides of the transaction, is presumed to have an easier time resolving potential disputes than does a market relationship. The frequency of a transaction matters because the more often it takes place, the more widely spread are the fixed costs of establishing a non-market governance system” (Holmstro¨m et al, 1998).

Williamson has treated market trade as a default mechanism which is assumed to be more efficient than internal trade except when there are high levels of asset specificity, frequency, and uncertainty to such an extent that they can pull the transactions away from the markets. Since the markets comprise of the default mechanisms their advantages are not as explicitly spelled out as the costs. The functioning market in transaction cost economics is quite insignificant and in this context, several conditions have been put forward by Williamson to reduce the size of firms in terms of costs about bureaucracy, poor individual benefits, and dangers of internal politics. But these cost factors are not easy to assess and for this reason, have not been of much importance.

A noteworthy strength of the approach towards modern property rights as presented by Grossman and Hart (1986), is the spelling out of the cost and benefits integration in ways that do not depend on the existence of impersonal markets. The theory gathers strength from the nonhuman resources forming the defining basis for firms; the firm is considered to be a set of resources under general ownerships. If two separate resources are owned by a single firm, then it is an integrated firm and if the owners are different it implies that there are two firms and their transactions will be inferred as market transactions. Decisions regarding ownership of assets, implying firm boundaries; become pertinent since control over resources enables the owners to have bargaining power as and when unexpected contingencies make firms discuss how the future relationships are to be carried out. Owners of assets have the choice to decide how the asset is to be utilized and who will utilize it, limited only if there is a constraint imposed by law or there are obligations exerted from certain contracts.

Assets are seen as favoring the leverage of bargaining power which impacts the conditions set under future agreements which further enables future payoff from the newly established relationships. The standard property rights model is different in comparison to transaction cost economics in that bargaining power becomes strong after the investments. Therefore everything depends on how ownerships influence the opening investments, but it is required that such investments must be non-contractible.

The case of Nucor

An important shift in the production process is exemplified by Nucor, which is considered the most dynamic steel company in the USA during the past two decades. The company uses its mini-mills in making steel from scrap steel comprising mainly of old car bodies as its raw material. Nucor had an initial technological advantage and then commenced expanding assertively. But such a strategy entailed a lot of investment and in saving on capital outlay the company opted to outsource the complete requirement of its steel scrap. However, steel mini-mills have been conventionally known to have integrated backward to ensure adequate supplies of raw material as also because sourcing requires considerable knowledge. Nucor’s organizational model encouraged other mini-mills to emulate the strategy. In the UK, Co Steel went to the extent of relying only on a single supplier to make ready-to-use material that went into the company’s steel-making ovens.

The technology for producing such ready-to-use materials is quite complex since twenty to thirty different ingredients are used in making the final material for producing steel and considerable savings can be done by using the diverse inputs in an optimum manner. This process requires advanced techniques and the extensive exchange of knowledge with steel plants to match the input with the final product. For logistical reasons, the ready-to-use material has to be produced by the supplier at the premises of Co Steel to facilitate sharing of knowledge. It is evident that in transaction cost economics such situations are beneficial for integration. Despite such conditions, the steel industry is moving towards disintegration in believing that costs will be saved with specialization through the elimination of duplicate resources, reorganizing the supply chains, and enabling benefits for suppliers by way of enhanced accountability.

In property rights theory boundaries of the firms can be identified through the pattern of ownership of resources but control over resources becomes a delicate matter in the real world. Contractual assets are mostly created cheaply in serving almost the same purpose which is assigned by the theory towards ownership; in providing leverage to provide bargaining strength and thus the increase incentives on investments. In this context, contracts that allow decision rights just as they do in ownerships; such as those of Nucor or license agreements of other kinds. Governance contracts of this kind are effective instruments to regulate market relationships. When there is a higher level of disintegration, contracts of governance appear to become nuanced and complex. Firms are placed at the center of networking relationships instead of being permitted to act as owners of a specific group of capital resources.

The Case of BSkyB

BSkyB which is Rupert Murdoch’s satellite broadcasting system is a pertinent example of a winning company that has created immense wealth by creating ingenious contracts in becoming powerful over a large network of media firms. In this case, ownership of physical assets is not seen as being very important since satellite broadcasting is characteristic of complementary activities which include the acquirement and development of programming and ensuring the efficient distribution of systems such as satellites, home receivers, and transmitters. It also concerns developing devices for encryption to safeguard the interests of subscribers.

The Case of Microsoft

Another illustration is the web of inter-firm relationships that surround Microsoft. It is known that Microsoft is valued by the stock exchanges at over $250 billion, thus making the per-employee value to be more than $10 million. It is very little in the company that is related to the ownership of capital assets. The company leveraged its controls over software standards by using a large network of contracting companies and partnerships that are both formal and informal and in including partners and contracting companies from small start-up firms to GE, Sony, and Intel. Microsoft has been able to gain remarkable influence in information technology and the computer industry. It appears to be clear that the conventional hold-up logic is not entirely valid in elaborating on how the huge network was created and the kind of roles that it performs. If asset specificity is to be measured in terms of separation cost, the estimate for the break of the relationship, for example between Microsoft and Intel, would be enormous. Despite such a situation and the possibility of huge potential losses, not much worry is caused by the move towards ownership integration.

Biotechnology industry

Similar patterns are seen in the biotechnology industry where the functions of the varied firms are quite interrelated with different parties performing specialized functions in marketing and developing varied products. Many companies are involved in different collaborative practices. For example, Genentech had ten marketing agreements in 1996 and over fifteen formal research partnerships. A considerable amount of relationship-specific investment is made by firms and future conflict could occur after the investments have been made. But the systems are seen to be working fine, obviously due to the creative contractual resources, by way of licensing arrangements and patents which are the most ingenious. This is also made possible due to the forces of reputation in markets that are significantly transparent in keeping with the well-established professional relationship amongst the parties.

Other examples

Another illustration that may not be very familiar is the case of multi-unit retail businesses in demonstrating how ownerships are responsive to agency concerns. Some of such establishments are primarily based on conventional practices of franchise agreements whereby manufacturers contract with other firms to sell their products from dedicated facilities, as in the case of gasoline retail selling. Other businesses such as pest control services, hotels, and fast-food restaurants operate based on business concept franchising. Franchisors allow the use of their brand coupled with other services such as managerial training, recipes, advertising, and quality control checks, and charge a fee from the franchisee but the physical resources and production processes are managed and owned by franchisees. In some cases, the franchisors manage and own the businesses themselves (for example McDonald’s). There are several other examples of business owners that operate all outlets themselves and hire managers and employees to run the business, such as department stores and grocery supermarket chains.

Such differences occur due to several reasons. It is difficult to ascertain how asset specificity in terms of inventories, kitchens, cash registers, and real estate differ amongst supermarkets in a manner that transaction costs reasoning could result in any specific observed patterns. Mostly the assets are not considered to be specific in any way. An alternative method is to apply the Hart-Moore property rights model which can identify investments that are not contracted but are available to other firms if the franchise agreements are discontinued. Investments have to vary amongst different businesses in a manner that they provide better incentives to managers of outlets in the business and the business owners as well.

Arrow (1975) has argued in his economic theory papers that the transmission of information amongst upstream and downstream companies can be achieved by vertical integration. As observed in the case of Nucor this kind of information can work well without the existence of vertical integration also. Considerable complexities can arise if firms come up with enhanced product technologies. If this knowledge is shared with current and potential competitors it would be socially advantageous and both parties stand to gain under this situation, but the problem relates to how the trade is to be paid. The potential buyers will be unwilling to pay for new knowledge and ideas until they prove to be beneficial. The establishment of the value of the new ideas however requires that most of such knowledge has to be given away free. Repeated actions in this regard can be helpful even if competing incumbents exchange information on a wider level that is what is done usually. For instance, the use of benchmarking is extensively used whereby the cost of different procedures is compared amongst firms. When knowledge is enhanced on a large scale or if the transfer of knowledge involves consistent engagement and investment, the issue becomes more complicated. A spontaneous choice in this regard is to integrate and all claims relating to knowledge values are then supported by the financial responsibilities that go with coordination amongst cash flows and control rights.

Mergers and acquisitions

Theorists believe that transfer of knowledge is a common force for merger and acquisition and horizontal expansion of companies, specifically while new knowledge and techniques develop and when the learning process is taking place regarding new management systems, new markets, and new technologies. In the context of the present patterns of mergers and acquisitions and the levels of horizontal instead of vertical integration, many sectors are facing such periods of change. The pattern of globalization in businesses has led to premiums being placed on the acquirement and sharing of knowledge in firms that have affiliations across the globe. Two UK-based companies perfectly fit into the explanation of this pattern. Asian Brown Boveri is the biggest manufacturer of electric types of equipment and British Petroleum is the 4th biggest integrated oil company in the world. Both companies view learning and sharing of information to be effective practices in enhancing their competitive advantages. Both companies function in a decentralized manner whereby their respective headquarters are incompatible to directly transfer knowledge amongst their units spread across the world. The problems associated with the transfer of knowledge are viewed as forming a part of the issues relating to free-riding whereby independent firms share common assets. When bargaining becomes expensive, the problem is resolved by holding single firms responsible for taking the benefits as also for bearing the cost associated with the use of the given assets. Brands are examples of common assets which require to be managed by individual parties.

Example of UAE

The cement industry in the UAE is slated for vertical integration in the face of companies lacking consolidation in their businesses. The cement industry in the UAE faces constraints in terms of cultural dynamics and needs to consolidate in overcoming a financial crisis and competition from abroad. The building materials industry in the country is highly fragmented with eleven integrated manufacturers that tend to cooperate in selling at similar prices and have common platforms by way of the Cement Manufacturers Association. But consolidation in terms of vertical integration has been held up due to cultural dynamics in terms of complexities arising for a company in one emirate acquiring another company in another emirate. The sector faces difficulties from several fronts due to lower pricing power arising by way of competition from countries such as India, China, and Pakistan that offer cement at much lower prices. The UAE has recently been importing most of its cement requirements but there is considerable scope for vertical integration because of the rising number of integrated cement plants and stand-alone grinding operators that depend on imported raw materials. The industry is now in a nascent stage and it will not be long before the advantages of vertical integration can be exploited by entities in the sector.

Attractiveness of Vertical Integration

The attractiveness of vertical integration is dependent on the expected growth possibilities and the related profit potentials that go with layers. Options for growth are formed by technical opportunities as also by the growth of markets and the level of competition. For instance, even if the technical opportunity is low, meaning that innovations cannot be achieved, options for growth could still be good and profits can be high because of market potential or reduced competition. Layers can be strategically beneficial when knowledge transferability is less and the conditions of appropriability are feeble. The following matrix provides an explanation for strategic options for firms when resource positions and strategic attraction are combined:

Strategic
Attractiveness

Resource Position

low high
strong (1) Spin-off (2) Vertical integration
weak (3) Market-based contracting (4) Strategic alliance

When a firm’s resource positions are strong but the layers offer a relatively low strategic attraction, a spin-off of the layer should be opted for by the company. The spin-off permits the firm to concentrate its actions on more attractive strategic layers in the value chains which realize better alternatives for development and profit. Under such conditions, the spin-off can consider becoming a layer player to keep close business relations with the parent firm. This choice is beneficial when technical opportunity and growth choices are dispersed vertically and the company has to allocate scarce management, financial and strategic assets to a large number of appealing layers. If the less appealing development options are abandoned and the firm relies on external sourcing, it will regain its tactical flexibility in focusing on projects that are more attractive in the value chains.

Vertical integration is a reliable tactical option if the firm has strong resource positions and the planned attractions of the layers are high. Such activities are kept within the vertical boundaries of the firms by vertical integrators and other firms develop their respective business models related to their activities. Layer players that wish to enter the manufacturing process have to stress actions that can speedily build resource positions that are strong and which provide options of fast growth and tactical attraction.

Resource-Based Approach

The resource-based approach of strategies enables another concept towards vertical integration by focusing upon the significance of strategic resources for the boundary of firms. Long-term competitive advantage is achieved with the use of internal control of resources that have immense value, are not easily available, difficult to copy, and difficult to replace (Barney, 1991). Most of the established firms focus their attempts on using such strategic resources and the resources that are available internally, influence the vertical boundary of the firm. Additionally, to protect the firm’s strategic resources and competency, protective belts of other resources are utilized to protect the spillover of knowledge to suppliers (Hamel, 1991).

Market-based contracting is a better choice when the firm feels that the vertical layer implies a feeble resource position and low strategic attraction. In such cases, market-based sourcing from external suppliers is considered sufficient. The bargaining power of suppliers becomes low in short-term market relations since companies can change suppliers at ease. This means that innovations can be used for standard modular products otherwise the cost of switching will prevent strong relationships.

If a company deals with a vertical layer that is strategically strong and attractive but has a feeble resource position it must opt-in entering into collaborative strategies and alliances with layer players. Strategic alliance permits stronger coordination as compared to market-based contracts and allows the company to have access to the non-transferable knowledge base of layer players. Strategic alliance influences corporate strategies in two ways; firstly the alliance partnerships require overlapping of their resources or capability of systems integration and secondly strategic alliance is characteristic of facing competition and cooperation at the same time as revealed by Brandenburger and Nalebuff (1995). Partnerships in this context imply that higher values are delivered and the realized surplus is split amongst them. Higher values could lead to conflicts and harm the firmness of the partnership. Spillover of knowledge can threaten strategic alliances and the partnering firms have to find preventive measures to avoid such risks. Moreover, the reputation and mutual trust of the strategic partnership can lead to meaningful implementation of the strategic alliances.

Discussion

Choices in Vertical Integration

It is important to understand how entrepreneurs transform the firm’s boundaries on the strength of new ideas. While developing a model in this regard it is required to focus on the nature of cash limitations faced by entrepreneurs and on the kind of return that is expected from the ventures as also the type of transaction issues related with vertically integrated as against being integrated along value chains. Theorists believe that transactional circumstances do not form the basis for predicting the potential of any venture but other factors are yet to be exhaustively researched in finalizing the strategic approaches. Given that the main goal for firms is to make profits this analysis can be expanded by finding how money-making measures influence the suitable choices in vertical integration. The results in this regard highlight the role played by capital appreciation which is better understood in terms of the motivating factors of economic activities including the choices regarding firm boundaries.

The paper has examined issues of vertical boundaries of the firm which is a major area of research in the literature about strategic management. The theory in the paper is elaborated in the context of an internal organization when economic changes happen for the better in distinguishing between the impact of change and the impact of the extent to which the markets are covered. This portrayal lays the basis for the appropriability and entrepreneurial variations of the theory as outlined in the paper.

Having been faced with intense rivalry with competitors, several firms that were vertically integrated, opted to outsource many of their activities to outside suppliers. The theoretical basis was made possible by the market-based viewpoints of strategy, mainly from the frameworks of value chains as modeled by Porter’s principles. This strategy focused on the bargaining powers of suppliers and their ability to exploit activities of internal synergy, uncertainty in markets, and the firm’s vertical boundaries. During the early 1990s, transactional cost economics had become the dominating concept in resolving the problems regarding firm boundaries. Although the uncertainty and occurrence of dealings are thought to be meaningful, the specificity of the capital and the value chains is of much relevance in the area of vertical integration. The specificity of assets results in a lack of symmetry in the bargaining power of the concerned forms which impacts the benefits available for investing in relationship-specific resources. If the resources are definite, vertical integration will ensure the optimum investment into the resources thus creating an effective firm in the given value chain.

Role of Outsourcing

By outsourcing weak performing activities the firm can enhance its profitability and strengthen its market position by stressing actions that result in competitive advantage. The de-averaging process enables a strong purpose for vertically integrated firms to deconstruct and companies which focus on single layers in the value chain of the industry facilitate this process. According to Edelman (1999), specialized layer players claim superior positions in exploiting the opportunities for growth in specific parts of the value chains as compared to vertically integrated firms. The averaging of the production actions means that all development opportunities in the value chains are not adhered to which makes vertical integrators suffer from disadvantages. As per this approach, the layer players are the major strengths of vertical disintegration since they enhance competition on vertical integrators thus forcing them to deconstruct in avoiding risking the loss of their competitive positions in the value chains. Thus the vertical organization of the value chain is changed in having important implications for the market structures. Barriers to entry are reduced, processes and product innovations are accelerated and competition is intensified.

In terms of vertical integration, the issue of firm boundaries was first highlighted by Coase in 1937 in revealing that entrepreneurs relied on weighing the benefits of internal productivity against the cost and risk attached with using the markets. But it was almost forty years later that some economists pioneered in developing a theory to enable the knowledge of transaction cost economics which showed that under specific circumstances the cost of utilizing the markets would make firms decide the internalization of transactions by producing in-house. According to Williamson (1985), a firm will decide about its boundaries in keeping with options that favor the integration of specific transactions within its structure of governance to produce instead of buying. Hence, as confirmed by a large body of theoretical and empirical research it is vital to understand what determines the specificity of assets for a given firm (Shelanski & Klein, 1995; David & Han, 2004).

According to Michael Jacobites (2005):

“Over the last decade attention has shifted towards examining how the capabilities and idiosyncratic aspects of firms might affect their boundaries. It is recognized that firms might be packages of competence, whose scope is path-dependent. It thus became accepted that the decision about whether to integrate or not may be related to the firm’s capabilities, and how best to profit from them. The decision about whether to make or buy was based on both capabilities and transaction costs, a finding that is replicated in large-scale studies. These studies suggest that in setting their boundaries, firms have to take account of their own particular conditions and circumstances. In this regard, the most seminal conclusion comes from the manner in which an innovator or entrepreneur should organize the scope of his venture on the basis of transactional characteristics” (Jacobides, 2005).

Jacobides (2005) has explained by using the mortgage banking sector in the USA how vertical disintegration changed a group of almost the same integrated firms towards vertical specialized entities by way of support providers, asset holders, mortgage bankers, mortgage brokers, and special service providers in coexisting with larger integrate companies. This procedure permitted dormant profits from trading which were achieved due to the transformation of the industry resulting from entrepreneurial interventions. This originated to some extent from new entrants which included firms that could collaborate with other firms in serving the emerging needs in the sectors. The shift also resulted due to initiatives taken by entrepreneurs who exploited the newly created vertical structures such as infrastructure and technology providers.

Example of UK

Examples of such entrepreneurship can also be found in the UK construction sector wherein an integrated all-in-one market emerged. The construction sector in the UK was transformed from a fully disintegrated sector to a market that was much influenced by vertically re-integrated firms. Under such conditions, firms realized the potential of reorganizing the production processes into new offerings. In doing so, firms that initiated the reintegration process worked with regulators in ensuring the lifting of constraints on provisions of integrated services. New ways were devised to connect with clients and to finance new constructions which would permit the new structures to become financially viable. Therefore firms were able to devise methods in leveraging the current skills and to make sure that older structures and roles were altered in their favor. The increasing use of information and communication technology has made it convenient to share the information beyond a firm’s boundaries thus enabling the sourcing of additional activities to external suppliers.

Transaction governance is sometimes considered a complexity in terms of governing capabilities for development and comparative logic is used in explaining the decision-making process for boundaries. The difficulties faced are highlighted while interpreting the current literature which aims at comparing abilities and explanations for transaction costs of firm boundaries. The literature in this regard concludes that transactions are organized in specific patterns at given times, rather for comparison instead of for transactional costs. Nicholas Argyres has held in this regard that:

“The distribution of specialized capabilities across firms and their buyers and suppliers at a particular point in time reflects a series of past decisions by these firms to either develop or not to develop capabilities internally. Thus, the possession of a capability today reflects a choice to internally develop (or purchase) that capability yesterday. These decisions, we argue, were likely driven by comparative governance or transaction cost considerations. Consider the following example. A firm decides to internalize an activity at time 1 because performing this activity with the desired level of capability requires highly idiosyncratic investments—investments that suppliers are reluctant to make in the absence of carefully crafted safeguards. Due to the high costs of contractually creating and enforcing these safeguards, the firm chooses to integrate this capability development. As these specific investments are made over time, the firm develops the desired, superior capability to perform the activity, so that by time 2, the capability is fully developed, leaving no outside supplier with a comparable capability. Thereafter, the firm continues to be integrated” (Argyress, 2007).

Ford Motor Company

There is a dynamic interaction amongst transaction capability and costs in terms of boundaries of firms which is evident from the choices made by the Ford Motor Company in the USA. Some of the main boundary choices made by Ford were the results of transaction cost analysis and such choices led to capability enhancement by the company which in turn impacted the boundary choices made in the future. Going back to history it was observed that in 1909 Ford had a supplier base in the automobile industry that was fairly well developed but it made a choice to integrate vertically into auto components and commenced with its assembly lines in the same year. Firm-specific single-purpose machine tools were required that were mainly designed by its Highland Park Plant. The firm’s specific investment entailed the creation of machine tools for assembly lines at a huge cost, which in effect was the main reason for Ford to decide in favor of vertical integration.

Ford continued over time to persist with its strategy of vertical integration and remained vertically integrated up to the early 1930s although other auto companies vertically disintegrated. Evidence was provided about several companies except for Ford that vertically disintegrated after 1926. This was because Ford could produce specialized machine tools required for assembly lines which the suppliers at the time were unable to supply. Ford was a leader for over fifteen years in this regard which enabled it to enjoy low component costs after integration. Thus Ford had transaction cost advantage and capability development which over time gave it a distinct advantage over its competitors.

Disney

Another example is Disney’s historical pattern of sourcing animation activities which demonstrates the relationship between complementarity, specialization, and boundaries of firms. Complementarity played a vital role for Disney in creating competitive advantages. The company’s management could perceive the strong complementary relationship between investing in films, theme parks, music, magazines, and books. Disney also realized that animation film production was an activity that was complementary to its other functions (Collis and Montgomery 1995). In considering the relations amongst the company’s major abilities and resources, an argument has been made by Argyress (2007) regarding the boundary choices and partnerships in specialization made by Disney; “first, one could make the case that no other bundle of complementary activities gains more value from superior capability in animated film production than the bundle of complements owned or assembled by Disney. In this sense, Disney’s other activities have not only been complementary with, but uniquely complementary with (or cospecialized to) a capability in animation. Our argument would then predict that attempting to access this type of highly co-specialized animation capability through contracts rather than internal organization would leave Disney vulnerable to the appropriation of quasi-rents” (Argyress, 2007).

By the late 1990s, Disney could not be consistent in possessing the unmatched capabilities in the animation industry after the top slot was taken over by Pixar that had acquired the most technically advanced animation capabilities in the industry. Initially, Disney made use of this new technology by way of a contractual relationship with Pixar and a multi-film agreement was signed between the two companies after the success of Toy Story and very soon Disney became dependent on Pixar which began to gradually appropriate a larger share of the profits generated from the venture. However, the partnership was eventually canceled in 2004. Disney negotiated to acquire Pixar to get hold of its unique capabilities and the acquisition materialized in January 2006 for $7.4 billion which analysts considered was very high (Argyress, 2007). The major learning from this example is that superior capability was not the only reason to drive integration decisions in Disney’s case. Rather, capability proved to be complementary with the partnership in the specialization as compared to Disney’s other activities.

Unresolved Issues

Although such strategies throw light on the question of vertical integration several issues remain unresolved. While innovation is thought of as being a major element that influences the vertical boundaries of the firm, it is mostly an afterthought in using such approaches. Further, the decision to outsource is viewed more like a scale-down of the firm’s actions to achieve short-term profit, but the implication for the long-term growth of the firm is mostly not addressed. The ability of firms to create and exploit technological innovations is a vital element in the competitive environment in different industries. The research and development capability of firms is normally assumed as being a crucial determinant of such capabilities.

Conclusion

This paper has considered how better understandings of entrepreneurial activity can assist in explaining the changes in the boundaries of firms and industries over time. Attempts have been made to arrive at a thorough understanding of boundary settings in which the actions of entrepreneurs are directed. In making use of the theories of firm boundaries arguments have been examined whereby entrepreneurs believe to be taking appropriate decisions by employing theoretical ideas in different parts of value chains. On the strength of what has been observed, a model is created in which the firm engages in value setting of the upstream ideas and the downstream components of value chains, in addition to the different ways in which the two components can be used beneficially in the value chains to bring better results. The entire research is based on the assumption that firms have the maximization of wealth as the major objective in carrying out the activities. Observations are made regarding the presence of transactional risks and other factors that make integration a better option as compared to specialization. The scope for this purpose depends on several factors that have not yet been explored by theory; particularly in the context of how severe is the constraint about the firm’s cash flows and how much value is added by firms’ knowledge levels in different parts of the value chain.

Firms are known to focus their efforts in areas where they expect the maximum yields of profits against the cash flows that they have. This criterion implies that the decisions made in this regard are dependent on the extent of liquidity available and the level of demand for the new knowledge and initiatives in the industry. Consideration has also been made regarding the impact on firms that admit to having made profits from their operations as also from other actions such as selling of capital assets and other resources of the firm. This results in a change in the optimum choice made by the firm’s boundaries since firms have to be prudent in deciding upon the segments that will bring benefits not only by way of profits but also by way of appreciation of assets. It is better to act in focusing upon the options that affect the choices of boundaries open for a firm instead of acting generically on the boundaries of firms. The choices have to be made by an individual firm in considering the conditions that are faced by it.

The relevant theory supports the belief that efficient boundaries of a firm are dynamic and can be substantiated by building upon transaction cost economics and the knowledge-based theory of the firm. In stressing the role of technological change, this paper has analyzed the contention of economists in using the concept of deconstruction, recent business paradigms, and altering market concepts in explaining the vertical integration of firms. This paper provides new perceptions and has revealed how theoretical foundations broaden the appeal of research in boundaries of the firm by including the knowledge base from the dynamic capability approaches and of progressive economics. The paper demonstrates how technological change in terms of technological opportunity, new knowledge, transfer of knowledge and other appropriate circumstances influence the firm’s decisions to alter the value chains, choice of business models, and the progression of the market conditions. Such circumstances result in new business models that are nonspecific and based on this analysis a strategic framework has been developed that will assist firms in picking the most attractive options in the industry’s value chain.

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