Corporate Strategy Diversification - Prof. Dr. Bernd Venohr

Vertical diversification: Transactions cost exist,
when there is market failure (market transactions
inappropriate or too costly), which in turn lead to firms
vertically integrating
� A vertical market "fails" when transactions within it are too risky and the contracts designed to
overcome these risks are too costly (or impossible) to write and administer. Where transaction costs
are high , the firm is a more efficient means of organization
� Examples (causes) of“market failures”:
– One Seller, One Buyer
– Difficulty in Writing Contracts: Bounded Rationality; Opportunism; Pre – Adverse Selection; Post - --
Moral Hazard
– Asset Specificity
– Frequency of Transaction: The more frequent a transaction, all else equal, the more likely integration will
occur
� By vertically integrating a firm makes its resource decisions internally, using management
mechanisms, as opposed to using the market . The objective is to adopt the organizational mode that
best economizes on transaction costs, minimizes the risk of market failure, while taking into account the
expense of governance costs. Firms must balance transaction costs with the cost of governance.
� Rapid decline of vertical integration in the last few years: rise of outsourcing
– advances of computer technology allow for easy cooperation between companies (lowering transaction
costs and incentive and coordination poblems)
– increased ability to write more complete and enforceable contracts
Source: Coase, Ronald. "The Nature of the Firm".; Wikepedia
© 2006 Dr. Bernd Venohr
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