This chapter discusses the strategic decision of whether firms should integrate activities internally ("make") or use external suppliers ("buy"). Transaction Cost Economics (TCE) argues integration depends on minimizing transaction costs based on factors like asset specificity, uncertainty, and opportunism. Horizontal integration occurs through mergers in the same industry, while vertical integration moves upstream/downstream. Outsourcing involves moving activities to external suppliers. Firms must consider capabilities, resources, costs/risks, and benefits when deciding to make or buy.

1. Strategy Theory and
Practice
© Stewart R. Clegg, Christos Pitelis,
Jochen Schweitzer & Andrea
Whittle

2. Chapter 5
Strategy: Make or
buy?

3. Learning objectives
• Understand the importance of transaction costs in
determining the strategic decision of whether to integrate
(‘internalize’) or outsource (‘externalize’)
• Explain the key concepts used in Transaction Cost
Economics, including transaction frequency, bounded
rationality, opportunism, feasible foresight, uncertainty and
asset specificity
• Identify the difference between vertical and horizontal
integration
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4. Learning objectives
• Understand when and why firms
integrate horizontally (merge or
acquire another firm in the same
line of business) and the
challenges of achieving horizontal
integration
• Explain the advantages and
disadvantages of outsourcing
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5. Horizontal/vertical integration and
outsourcing
• Horizontal integration occurs when a firm acquires or
merges with another in the same industry
• Vertical integration involves moving into activities that were
previously an input into the firm undertaken by one’s
suppliers ‘downstream’ (known as backward integration) or
part of the post-production process undertaken by buyers
‘upstream’ (known as forward integration).
• Outsourcing involves moving activities that were previously
undertaken by the organization to outside suppliers as
contractors.
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6. Transaction cost economics (TCE)
• TCE started life in a 1937 paper by Ronald Coase and was
developed further by Oliver Williamson
• Williamson drew on concepts developed by behavioural
theorists such as Herbert Simon and Cyert and March
• Williamson outlined the alternative models for economic
activity:
– market (buy)
– hierarchy (make)
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7. To make or buy? That is the question
• Madhok and Tallman (1998) outline four factors to consider
in deciding whether to make or buy:
• Lack of necessary internal capabilities and assets
• Unavailability of needed resources for purchase in the open
marketplace
• High cost or risk associated with purchasing a firm that has
the necessary resources
• Benefits of collaboration, such as evading extensive
organizational integration following a merger or an
acquisition and the preservation of critical assets and
strategic flexibility
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8. Transaction costs
• The economic costs that are
incurred when exchanging
(buying or selling) goods or
services.
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9. Organizational boundary decisions
• According to TCE, the boundary of the firm is a result of
economic considerations concerning ‘make or buy’, that is,
internalizing or externalizing activities
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10. Asset specificity
• The degree to which an
asset can be redeployed to
alternative uses without loss
of value
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11. Williamson and TCE
• Williamson’s (1981) development of Transaction Cost
Economics (TCE) focuses on efficiency
• Efficiency is defined in terms of reductions in transaction
costs
• The key question TCE raises is whether transactions should
be coordinated within a firm or across markets:
– Is a transaction more efficiently performed within a firm
through its vertical integration inside?
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12. Williamson and TCE
– Is a transaction more efficiently performed within a firm
through its vertical integration inside?
– Or should the firm use market mechanisms by buying it
from the outside from autonomous third-party
contractors?
– Hence, whether to make or buy?
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13. TCE proposes that human actors are
characterized by
• Bounded rationality (all complex contracts are unavoidably
incomplete because the buyer and seller cannot know in
advance and write in the contract all possibilities of what
might happen when they exchange the goods or services).
• Opportunism (the assumption that parties of long-term
contracts will breach the spirit of a contract if it is in their
self-interest to do so).
• Feasible foresight (the principle that parties to a contract
have the capacity to look ahead and to integrate those
insights into the ex-ante decisions, for example by setting
up contractual safeguards).
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14. Bounded rationality
• Bounded rationality is a term taken from March and Simon
(1958)
• It acknowledges the fact that we never have perfect
knowledge and hence can never be perfectly rational
• Because rationality is always ‘bounded’, it leads to parties
not being able to foresee all the possible consequences of a
contract
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15. Opportunism
• Opportunism prevails when:
– actors try to gain advantage by being economical with, or
even distorting, what we take to be the ‘truth’
– the possibility of opportunism ensures that there is also
the possibility of uncertainty about agreements being
maintained (for example, a buyer not paying for
something bought on credit)
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16. Factors predicting firm formation
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17. Uncertainty
• Uncertainty is associated with
the unfolding of events
relevant to contracts, the
contingencies of which cannot
necessarily be controlled
• Uncertainty is positively
related to hierarchical
governance, due to the power
of managerial fiat
(Williamson, 1975, 1985)
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18. Three types of uncertainty
• Volume uncertainty – being unable to predict the amount of
materials needed
• Technological uncertainty – being unable to forecast
technological requirements
• Behavioural uncertainty – being unable to predict or control
the behaviour of the other party
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19. Asset specificity/transaction
frequency
• Asset specificity refers to the degree to which an asset is
specific to use or user
• Transaction frequency refers to the repeatability of
transactions (i.e. how often transactions occur)
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20. How hierarchies solve the market
failure
• Hierarchies solve the market failure problems that result
from contracting through (vertical) integration in three ways
– Information flows.
– Negotiating costs.
– Incentive alignment
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21. Market failure
• Information flows
– You can gain access to information more easily if you
bring it in house
– By doing so, you can have better auditing capacity to
receive critical information and impose controls
– You can also tell staff how to keep their books
• Negotiating costs
– You can also reduce the costs of negotiation. Hierarchy
imposes a system of authority that is characterized by a
unilateral dispute mechanism
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22. Market failure
– People in authority positions can say how to do things
and get them done
• Incentive alignment
– Through vertical integration, there is no longer any
incentive for a firm to not make investments in specialized
assets
– Once the same firm owns everything, opportunism in the
ownership and control of specialized assets will not occur
– So vertical integration brings about an incentive
realignment
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23. Concurrent sourcing
• Firms can both make and buy the same good, using
‘concurrent sourcing’
• Concurrent sourcing is used in situations when, for instance:
– demand uncertainty pushes fluctuations in volume onto
suppliers in order to ensure full internal capacity and
stable production
– the use of both owned and franchised outlets balances
incentive and control issues, as well as facilitating
learning
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24. Concurrent sourcing
– abundant raw materials or subcontractors are readily
available and physical interconnectedness is unnecessary
– high economies of scope of both buyer and supplier and
diseconomies of scale are insubstantial, so that
bargaining power is strengthened by the opportunity to
benchmark and better evaluate the performance of
internal and external suppliers
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25. Applications of TCE
• The multi-divisional (M-form) organization simplifies the
informational and decision-making situations by clearly
differentiating between the long-range policy decisions to be
handled by the general office and the short-term operational
decisions to be determined at divisional level
• Business units become profit centres, and the Head Office
an internal capital market that receives profits and allocates
resources
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26. M-Form
• From the TCE perspective, the M-form (internal capital
market) possesses important advantages over the external
capital market:
– It has easy access to more accurate information about
divisions.
– It can manipulate incentives more easily.
– It can exercise control over the strategies pursued by
divisions.
(Barney and Hesterly, 1996)
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27. M-Form
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28. Problems with TCE
• The market and hierarchy distinctions that TCE sculpted,
have blurred:
– Coopetition refers to cooperation designed to provide
mutual gain between businesses that have previously
seen each other as competitors
– Emergent forms of networks, such as in the field of open-
source software or, more recently, in some manifestations
of the sharing economy, challenge the ideas of
embeddedness and knowledge networks
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29. Problems with TCE
• TCE does not explain how that market came into being
• TCE assumes firms have an effective hierarchy and
agreement on goals
• TCE understates the cost of organizing – including costs of
haggling and transactions within the firm
• TCE’s view of economic activity remains too rational – firm
behaviour is not always rational and driven only by cost
• TCE neglects the role of social relationships (‘embedded
ties’) in economic transactions
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30. Embeddedness or ‘embedded ties’
• Refers to the way in which economic activity is influenced or
constrained by non-economic institutions, such as kinship
relations, religious institutions or political institutions.
• These ‘ties’ mean that economic activity is not guided by
rational economic calculations of maximising payoffs, but
rather is guided by norms and values shared by the social
group or by political or religious belief systems.
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31. Coopetition
• … refers to the coexistence of
cooperation with competition
between businesses aiming to
take advantage of the benefits
of both
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32. Vertical and horizontal integration
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33. Integration
• TCE considers two major forms of governance for
integrating (or internalizing) transactions within a firm:
– Horizontal integration occurs when a firm acquires or
merges with another
– Vertical integration involves moving into activities that
were previously an input into the firm undertaken by your
suppliers ‘downstream’ (backward integration) or part of
the post-production process undertaken by your
customers ‘upstream’ (forward integration)
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34. When to vertically integrate?
• Vertical integration is more likely when:
– There are common systems, standards and protocols
used by both parties, making ‘joining up’ easy
o Locating manufacturing outside the firm can make
cross-functional coordination much more difficult, given
the probability that locally differentiated systems will be
in use
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35. When to vertically integrate?
– Integration can provide enhanced information transfer
and coordination across activities
o With technologies that require a great deal of
coordination, it makes sense to try and secure these
in-house, inside the organization
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36. When to horizontally integrate?
• Horizontal integration is more likely when:
– It provides advantages such as:
o reducing competitive intensity
o lowering production costs through scale
o boosting differentiation by eliminating similar products
or services in the market
o providing access to new markets and distribution
channels (especially important for internationalization
strategies)
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37. When to horizontally integrate?
• Reducing competitive intensity can change the underlying
industry structure by taking out excessive capacity from
rivals and increasing industry consolidation
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38. M&A
• Mergers involve two firms
combining to create a new
legal entity.
• Acquisitions involve one firm
purchasing another firm,
meaning the acquired firm
ceases to exist.
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39. Cultural integration
• ‘Cultural integration is said to
occur when changes are
made in two different cultural
systems because particular
elements of culture have
spread from one system to the
other, in both directions’
(Berry, 1980: 215)
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40. Acculturation
• Van Marrewijk (2016) identifies four strategies for
acculturation:
– Integration: when the two cultures are integrated, each
retains its individual identity (Buono and Bowditch (1989)
define four strategies for integrating cultures in M&A:
taking over, blending, pluralism and resistance)
– Assimilation: when one culture absorbs the other
– Separation: when two cultures are entirely separate
– Deculturation or marginalization: when a culture
disintegrates
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41. Outsourcing
• Outsourcing is the mirror image of integration
• Activities previously done in the firm are moved out to a
contractor
• The growth of web-based and digital telecommunications
services enables more activities to be outsourced by
lowering transaction costs
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42. Problems with outsourcing
• Cost reductions are often over-estimated because of poorly
specified calculations
• Outsourcing causes additional costs:
o management costs in examining and deciding on
tenders
o employee costs in packaging and transferring
information
o legal costs in resolving disputes
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43. Problems with outsourcing
• The additional costs associated with outsourcing mean that
companies need several years to realize the financial
benefits
• Cost savings often occur at the expense of a reduction in
quality, a deterioration in work conditions and a decrease in
employment
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44. Conclusion
• You should now know about:
– Transaction Cost Economics (TCE)
– Vertical and horizontal integration
– The importance of culture in horizontal
integration
– Outsourcing
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45. References
• Barney, J.B. and Hesterly, W.S. (1996) ‘Organizational
economics: Understanding the relationship between
organizations and economic analysis’, in S.R. Clegg, C.
Hardy and W.R. Nord, Handbook of Organization Studies.
London: Sage Publications.
• Berry, J.W. (1980) ‘Social and cultural change’, in H.C.
Triandis and R.W. Brislin (eds), Handbook of Cross-Cultural
Psychology. Boston: Allyn & Bacon. pp. 211−279.
• Buono, A.F. and Bowditch, J.L. (1989) The Human Side of
Mergers and Acquisitions: Managing Collisions between
People, Cultures and Organizations. London: Jossey-Bass.
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46. References
• Madhok, A. and Tallman, S.B. (1998) ‘Resources,
transactions and rents: Managing value through interfirm
collaborative relationships’, Organization Science, 9(3):
326–339.
• March, J.G. and Simon, H.A. (1958) Organizations. New
York: Wiley.
• Van Marrewijk, A. (2016) ‘Conflicting subcultures in mergers
and acquisitions: A longitudinal study of integrating a radical
internet firm into a bureaucratic telecoms firm’, British
Journal of Management. doi: 10.1111/1467-8551.12135.
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47. References
• Williamson, O.E. (1975) ‘The economics of governance:
Framework and implications’, Journal of Theoretical
Economics, 140: 195–223.
• Williamson, O.E. (1981) ‘The economics of organizations:
The transaction cost approach’, American Journal of
Sociology, 87(3): 548–577.
• Williamson, O.E. (1985) The Economic Institutions of
Capitalism. New York: Free Press.
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