Vertical Coordination and Contract Farming
Rehber
technological uncertainty and asset specificity. Mahoney
(1992) presented an organizational form prediction
considering the interactive effects of the task
programmability, task separability and transaction cost
of asset specificity (Table2.1).
Despite the general acceptance, transaction cost
economics is also heavily criticized. The importance of
transaction costs seems to be over emphasized. Indeed,
transaction costs are important but they are not
everything (Boon 1999). In short, vertical integration is a
form of governance structure and can lead to lower
transaction costs.
McFetridge (1994) suggested another theory called
imperfect competition or neoclassical approach as a
complementary approach to the transaction costs theory.
The imperfect competition approach to vertical
integration is concerned with the opportunities for
vertical exchange that arise as a consequence of
imperfect competition at one or more stages of
production.
He argued that, theoretically, imperfect competition
at one or more stages of production makes either vertical
restraints or vertical integration profitable. “ One well
known example is the successive monopoly or
successive marginalization problem. The replacement of
successive monopolies by a vertically integrated
monopoly is both profitable and welfare increasing”
(McFetridge 1994).
2.2.3. Strategic Management.
This concept is derived from Porter’s value chain
strategies to develop a strategic competitive advantage
and the criteria or considerations in the integration (buy-
versus-build) decision. According to Porter, the basic
unit of competitive advantage is the discrete activities.
The firm is a collection of discrete but interrelated
activities and firm’s strategy defines how they are
interrelated. Hence, competitive advantage will result
“from a firm’s ability to perform the required activities
at a collectively lower cost than rivals.” The central
interest of Porter’s approach is that vertical coordination
is a result of a firm’s behavior. Boone and Verbeke
(1991), in their analysis used a “strategic management of
contractual relations” concept wherein the benefit is
normally associated with a hierarchical organization. For
them, vertical coordination can be explained in terms of
transaction costs (Sauvee 1998).
Harrigan (1986) explained the dimensions of vertical
integration as degree, stage, breadth, and form and tried
to measure them. She took a classical strategic
management perspective on vertical integration and
outlined four main factors that determine the choice of
vertical integration. These factors are demand and
infrastructure uncertainties, market stability, bargaining
power and corporate strategy requirements (Harrigan
1986).
A transaction can be organized within the firm or
through the market, but organizing a transaction within
the firm does not eliminate contracting costs, since by
doing so one replaces a contract for intermediate input
with employment contracts. Choosing the appropriate
mix of contracts and improving the efficiency of each
type is a source of competitive advantage (Hernart
1994). In other words, competitive advantage arises
from inter-firm differences in their organization
capacities and also taking into consideration bureaucratic
costs and the incentive problem of hierarchy. Hennart
(1994) extended the definition of transaction costs
stating that while economizing on transaction costs,
vertical integration may increase the bureaucratic costs.
He argued that using an appropriate coordination
strategy is important within the firm and on the market.
Zajac and Olsen (1993) have indicated that the
standard transaction cost theory is a one-sided analysis
of cost minimization and neglects the interdependence
between partners. They attempted to provide a new
perspective on transaction cost analysis by offering a
transactional analysis framework based on joint value
maximization instead of a single-party analysis of cost
minimization and by proposing a set of processual
dimensions relevant to create and claim value by
partners. They did not claim that transaction costs do not
exist or are irrelevant to the study of inter-organizational
strategies. According to Zajac and Olsen, process/
behavioral aspects of inter-organizational must be
considered (Zajac and Olsen 1993).
From the strategic management point of view, the
incomplete character of transaction cost analysis leads to
overestimation of advantages of vertical integration.
Both market transactions and vertical integration are
inefficient. Therefore, the main challenge of the firm is
to develop strategic management of the contractual
arrangement.
2.2.4. Negotiating Power and Performance Incentives.
Another set of arguments that may help explain the
choice and implementation of various coordination
mechanisms relates to the concept of negotiation power
and performance incentives. In negotiated coordination
among stages in the food chain, the invisible hand of the
market is replaced by the very visible hands of buyers
and sellers negotiating the terms of trade in many cases
prior to the production or manufacturing process. In such
a system, phenomena such as negotiating strategy, skill,
power, conflict resolution, trust, performance
monitoring, and evaluation become central in the
Food Marketing Policy Center Research Report #52