How Capability Differences, Scale, Learning curves and Transaction Costs Interact to Shape Vertical Scope

This paper provides an integrative analysis of the drivers of vertical scope, using analytical and computational methods. I propose a model with two vertical segments (upstream and downstream), with firm populations that have heterogeneous capabilities, and an intermediate market subject to transaction costs, where firms can choose whether to be integrated or vertically specialized. By varying the level of transaction costs and changing the structure of the correlation between upstream-downstream capabilities in the industry, as well as economies of scale; learning curves; and the way in which profitability leads to capability improvement in the upstream and downstream segments, I generate numerical results to explain how vertical integration evolves over time. The results suggest that (a) without capability differences, even if transaction costs are nil, firms remain integrated; (b) differences in economies of scale in the two segments may create or dampen specialization, depending on the underlying capability heterogeneity structure; (c) transaction costs...