The Make-or-Buy Decision: Lessons from Empirical Studies

Abstract

Should a firm make its own inputs, buy them on the spot market, or maintain an ongoing relationship with a particular supplier? The emergence of the transaction cost approach to vertical integration in the 1970s and 1980s generated a substantial body of empirical research on vertical firm boundaries and related issues in contracting and organizational design. This chapter reviews the empirical literature on the make-or-buy decision, focusing on the transaction cost approach. After reviewing the Coasian or "contractual" approach to vertical integration I summarize the most common empirical strategies, highlighting current controversies over data and methods, sample selection, and related issues. I next provide a sampler of evidence on component procurement, forward integration into marketing and distribution, contractual design, and the use of informal agreements. Finally, I discuss outstanding challenges and directions for future research, focusing on the measurement and definition of key variables, the role of asset specificity, the comparison of rival explanations, causality, and the effects of the legal and regulatory environment.

Keywords: vertical integration, transaction costs, contracting, empirical research

JEL Classification: D23, L22