Production Technology, Information Technology, and Vertical Integration Under Asymmetric Information

The paper addresses the effect of technological progress on the boundaries of the firm, building on transaction cost theory and agency theory. The model incorporates four types of costs: production, coordination, management, and transaction costs. The market has lower production costs, but higher coordination costs, than the firm. A principal-two agents framework with adverse selection and moral hazard is adopted. It is found that technological progress in production and information technologies tend to have diametrically opposite effects on procurement. In general, progress in production technology leads to more vertical integration, whereas progress in information technology leads to more subcontracting. When technological change concerns the level of costs, its effect on procurement depends on the cost differential between the firm and the market, and on the relative importance of production and coordination costs; whereas, when technological change affects the effect or disutility of effort, its impact on procurement is unambiguous. The paper provides an explanation for the changing effect of technological progress on procurement throughout the twentieth century: why it favoured vertical integration historically, and why it favours subcontracting (or has a mixed effect) today. This explanation relies on the implication of the evolution of the relative importance of production and coordination activities for the relationship between technological progress and vertical integration. The paper constitutes a bridge between contractual explanations and technological explanations of the existence and boundaries of the firm