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Firms' Procurement Decisions: Is Input Specificity Always an Argument for Vertical Integration?

Thiele, Veikko (2008): Firms' Procurement Decisions: Is Input Specificity Always an Argument for Vertical Integration?

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Abstract

The transaction cost theory predicts that firms are inclined to vertically integrate transactions in response to the specificity of their required inputs. Yet, reality proves that some firms engage in repeated transactions with external suppliers aimed at procuring highly specific inputs. To explain this phenomenon, this paper investigates a firm's make-or-buy decision in a context with relational (i.e. non-enforceable) contracts, and exposes how this decision is affected by the required input specificity. This paper demonstrates that a high degree of input specificity can lead to repeated market transactions being favored over vertical integration because demanding more specific inputs is shown to (i) impose lower costs on firms to maintain repeated market transactions founded on relational contracts; and (ii), facilitate the self-enforcement of these relational contracts.

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