Vertical Integration as Firm-Level Response to Electricity Shortages : Does Transaction Cost Economics Explain?

In developing countries, industries are often plagued with power shortages. In response, some firms make their own electric power but most of the others do not. Why do we observe such divergent behavior in the decision to self-generate? Previous literature focuses on factor demand and marginal cost structure as key determinants for the decision to self-generate but does not explain divergent behavior in firms with similar characteristics. We take the perspective of contractual relationships and treat electricity provision as a transaction. Applying a discrete choice ‘make or buy' model on a primary dataset of Indian manufacturing firms, we find that it is the sensitivity to ‘transaction-specificity' in electricity use that makes them opt for self-generation. But this is constrained by contextual factors like firm size, location and operational environment. We conclude that even a standardized and physically non-specific asset can generate ‘transaction-specific' costs, if the context demands so. We contend that transaction cost economics not only explains vertical integration of electricity by firms but in similar contexts can be used to explain the industrial organization of other energy resources which may otherwise be non-specific in nature