The decision to vertically integrate depends not
only on the costs associated with transacting over
markets, but also on the internal costs of producing
within the firm. The effectiveness of integration
depends on the ability to evaluate and monitor
employees and the ability to effectively discover
and convey information. These capabilities are
affected by firm size and the type of organizational
structure.
One strand of the literature on the relationship
between internal costs and firm size examines diseconomies
that arise with cumulative control loss
(see, e.g., Williamson (1970)). Others have examined diseconomies arising from the fixed nature
of managerial capital (see, e.g., Penrose (1959)).
The presence of diseconomies has direct implications
for the decision to vertically integrate.
Because the stock of managerial capital is fixed at
any point in time, increases in the scale of a
particular activity must be weighed against the
addition of upstream and downstream activities.
Thus, the level of vertical integration is expected
to be negatively related to the scale of the firm's
primary activity. Nonvertically related, i.e., conglomerate, activities
provide competing uses for the firm's stock of
managerial capital. In fact, the demand for
managerial capital in producing new or different
activities is often greater than in producing related
products.7 Consequently, the tradeoff between engaging
in vertically related and nonrelated activities
will be investigated separately from the tradeoff
between engaging in vertically related activities
and the firm's primary area of specialization.
Again, the tradeoff implies a negative relationship.
Implementation of certain organizational structures
may enable firms to relax diseconomies associated
with firm size. Most notably, firms have
adopted the multidivisional (or M-form) organizational
structure to replace the traditional functionally
organized structure (see Williamson (1975)).
Superior planning, coordination and control is
achieved by decentralizing operating decisions
while centralizing strategic decisions. Thus, the
presence of the M-form organization is expected
to be positively related to the level of vertical
integration.