Contracting for Innovation: Vertical Disintegration and Interfirm Collaboration

Abstract:     
Rapidly innovating industries are just not behaving the way theory expected. Conventional industrial organization theory predicts that when parties in the supply chain have to make transaction-specific investments, the risk of opportunism will drive them away from contracts and toward vertical integration. Despite the conventional theory, contemporary practice is moving in the other direction. Instead of vertical integration, we observe vertical disintegration in a significant number of industries, as producers recognize that they cannot themselves maintain cutting-edge technology in every field required for the success of their product. In doing this, the parties are developing forms of contracting beyond the reach of contract theory models. In this Article, we connect the emerging contract practice to theory, learning from what has happened in the real world to frame a theoretical explanation of this cross-organizational innovation and to reconceptualize the boundaries of the firm accordingly. We argue that the vertical disintegration of the supply chain in many industries is mediated neither by fully specified technical interfaces that allow suppliers to produce a modular piece of the ultimate product, nor by entirely implicit relational contracts supported only by norms of reciprocity and the expectation of future dealings. Rather, we suggest that the change in the boundary of the firm has given rise to a new form of contracting between firms - what we call contracting for innovation. This pattern braids explicit and implicit contracting to support iterative collaborative innovation by raising switching costs. These costs, represented by the parties' parallel investment in transaction specific investment in knowledge about their collaborators' capacities, deter opportunism under circumstances when explicit contracting, renegotiation and the anticipation of future dealings cannot.

Keywords: vertical integration, contracting, switching costs, innovation

Working Paper Series