Strategic Management Journal

Strat. Mgmt. J., 26: 415–440 (2005)

Published online 11 March 2005 in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/smj.458

ADAPTATION IN VERTICAL RELATIONSHIPS:

BEYOND INCENTIVE CONFLICT
RANJAY GULATI,1 * PAUL R. LAWRENCE2 and PHANISH PURANAM3
1
Kellogg School of Management, Northwestern University, Evanston, Illinois, U.S.A.
2
Harvard Business School, Harvard University, Boston, Massachusetts, U.S.A.
3
London Business School, University of London, London, U.K.

In this study, we extend the analysis of adaptation in theories of economic organization

beyond traditional considerations of incentive conflict (hold-up). We conceptualize adaptation as
coordinated and cooperative response to change, and define the adaptive capacity of a vertical
relationship as the ability to generate coordinated and cooperative responses across procurer
and supplier to changes in procurement conditions. We draw on the concepts of differentiation
and integration to dimensionalize the adaptive capacity of different modes of procurement. Using
data on all component classes procured internally and externally by Ford and Chrysler, we show
that different procurement modes differ in terms of their adaptive capacity and performance. We
also show that performance differences across modes of procurement arise as a function of the
match between adaptive capacity and adaptation requirements associated with the exchange,
and not only the match between governance form and transaction hazards. Copyright  2005
John Wiley & Sons, Ltd.

INTRODUCTION In Oliver Williamson’s development of the theory,

Vertical (procurement) relationships have always
been the favorite empirical domain of theorists
of economic organization (Coase, 1937; Gross-
man and Hart, 1986; Williamson, 1975). Such
relationships involve exchange between adjacent
stages of the value chain, and they occur both
within firms (e.g., between different functional or
divisional areas within a firm) and between firms
(e.g., between specialist design firms and special-
ist manufacturers). In recent years, the study of
vertical relationships has come to be dominated
by transaction cost economics (see Shelanski and
Klein, 1995; David and Han, 2004, for reviews).
the focus is on ‘how parties engaged in a long-
term contract can adapt effectively to disturbances.
The need to craft contractual structures in which
they have mutual confidence . . .’ is the key issue
(Williamson, 1991b). Williamson also notes that
in addition to incentive conflict, failures of adap-
tation may arise ‘because autonomous parties read
and react to signals differently, even though their
purpose is to achieve a timely and compatible
combined response’ (Williamson, 1991a). Yet, this
theoretical recognition of adaptation problems that
might persist even in the absence of incentive con-
flict finds scant recognition in most prior research
motivated by transaction cost economics.1 In this

Keywords: coordination; organization design; differenti- 1

ation and integration; auto industry
∗
Correspondence to: Ranjay Gulati, Kellogg School of Manage-
ment, Northwestern University, Jacobs Center, 2001 Sheridan
Road, Evanston, IL 60208-2001, U.S.A.
E-mail: r-gulati@kellogg.northwestern.edu
We focus on transaction cost rather than property rights when
discussing existing literature on the economic organization of
vertical relationships. This is because the empirical strategy and
management literature on vertical relationships is much more
influenced by transaction cost economics than property rights
economics (see Novak and Eppinger, 2001, for an exception).

Copyright  2005 John Wiley & Sons, Ltd. Received 1 March 2000
Final revision received 10 November 2004
416 R. Gulati, P. R. Lawrence and P. Puranam
study, our goal is to broaden the conceptualization
of constraints to adaptation in vertical relationships
beyond incentive conflict to include constraints
arising from limited responsiveness to changing
exchange conditions and coordination failures.
The central and most investigated proposition
in transaction cost economics concerns a class of
adaptation problems resulting from the potential
for hold-up in vertical relationships (David and
Han, 2004; Masten, 2002; Shelanski and Klein,
1995). When procurement must be supported by
dedicated (relationship-specific) investments, the
anticipated costs of the transaction increase. This
is because dedicated investments by one party cre-
ate scope for the other to renegotiate the contract
opportunistically when circumstances change. By
organizing such transactions under common own-
ership, muted incentives, enhanced monitoring,
and the threat of sanctions can limit opportunis-
tic behavior and facilitate cooperative adaptation
(Williamson, 1985). However, we will argue in
this paper that adaptation failures in vertical rela-
tionships can also occur for reasons other than
hold-up (or concerns about hold-up). Even when
there is no incentive conflict, bounded rationality
can cause the parties to an economic relationship to
fail to recognize profound changes in the economic
environment, or generate a coordinated response
to such changes (Camerer and Knez, 1996, 1997;
Foss, 2001; March and Simon, 1958). The theoret-
ical challenge is to analyze these aspects of adap-
tation in addition to traditional hold-up concerns
within a parsimonious and integrated framework.
Along the lines of Williamson (1991a, 1991b)
we define the adaptive capacity of a vertical
relationship (within or across firm boundaries) as
the ability to generate coordinated and cooperative
responses across procuring and supplying units
to changes in exchange conditions. However, our
approach is distinctive from most prior empirical
research in that in addition to the traditional focus
on cooperation as the key aspect of adaptation,
we also emphasize responsiveness to change and
coordination of responses among the parties.
We draw upon some of the seminal research
on organization design to analyze our broader
conception of adaptation in procurement activities.
We assess the adaptive capacity of different modes
of organizing procurement using the concepts of
differentiation and integration. In prior literature
on organizations, these concepts have been used
to formulate principles for designing subunits
Copyright  2005 John Wiley & Sons, Ltd.
within organizations that could adapt to change
(Daft, 2001; Lawrence and Lorsch, 1967a, 1967b;
Nohria and Ghoshal, 1994). In this tradition,
organizational performance was argued to depend
on the match between environmental contingencies
and the extent of differentiation and integration
across organizational subunits.
We extend this analytical approach to vertical
relationships both between and within firms. We
argue that different modes of procurement—make,
buy, and ally—differ in terms of the extent of
differentiation and integration between procuring
and supplying units and therefore in their adaptive
capacity for responding to changes in the exchange
environment in a coordinated and cooperative
manner. We therefore expect that the performance
of a given procurement activity will depend
on the match between the adaptive capacity
of the specific mode of procurement and the
need for adaptation in the specific exchange
relationship that is in turn impacted by contextual
factors associated with the exchange. We test
this prediction through a switching regression
model of procurement performance, estimated
with data on the procurement arrangements
used by Ford Motor Company and Chrysler
Corporation for all their major components. Our
results show that performance differences across
modes of procurement arise as a function of the
match between adaptive capacity and adaptation
requirements associated with the exchange, and
not only the match between governance form and
transaction hazards.
THEORETICAL BACKGROUND
It is interesting to note that around the
time Ronald Coase was formulating his ideas
on transaction costs and their effects on
coordination in markets and firms (Coase,
1937), Chester Barnard (1938) was emphasizing
the importance of adjustment processes in
organizations. As with Coase, Barnard’s analysis
framed key contributions by later scholars
(e.g., Simon, 1945; March and Simon, 1958;
Thompson, 1967; Lawrence and Lorsch, 1967a,
1967b), who saw the essence of organizational
adaptation as the generation of integrated
responses to changed circumstances. The followers
of Barnard, however, emphasized the importance
of information rather than incentives (Grant,
Strat. Mgmt. J., 26: 415–440 (2005)

1996; March and Simon, 1958; Simon, 1945;
Thompson, 1967). Furthermore, while Coase’s
disciples focused on the boundary of the firm
by assessing factors that impacted the make-or-
buy problem, those who followed Barnard focused
primarily on intra-organizational coordination.
In the decades that followed, research in the
tradition of Barnard rapidly accumulated on
the design attributes of complex organizations
comprising multiple, interdependent subunits that
enabled them to achieve coordinated adjustments
to changes in their environment (Daft, 2001;
Galbraith, 1977; Nadler and Tushman, 1998).
We develop and extend this tradition of research
on organizational adaptation initiated by Barnard
to the inter-organizational context. We analyze the
adaptive capacity of vertical relationships in terms
of differentiation and integration (Dougherty,
2001; Ghoshal and Nohria, 1989; Lawrence and
Lorsch, 1967a, 1967b; Nohria and Ghoshal, 1994).
Differentiation refers to the differences across
organizational subunits that arise as a consequence
of their local adaptation to unit-specific tasks and
environments (Dougherty, 2001). Differentiation
at the subunit level increases the responsiveness
of the aggregate organization (and hence its
adaptiveness), as it creates organizational diversity.
Differentiated and diverse organizational subunits
can recognize and engage in a wider search for
new opportunities when environmental conditions
change (Cohen and Levinthal, 1990; Ethiraj and
Levinthal, 2004; Lawrence and Lorsch, 1967b;
Rivkin and Siggelkow, 2003). Integration refers
to the achievement of collaboration between
organizational subunits. It encompasses not only
cooperation (alignment of interest) but also
coordination (alignment of actions) (Camerer
and Knez, 1996, 1997; Foss, 2001; Heath
and Staudenmayer, 2000). Achieving integration
between interdependent organizational subunits is
necessary in order to respond effectively to change
(Nadler and Tushman, 1998; Thompson, 1967; Van
de Ven and Walker, 1984).
By analyzing organizational attributes that
emphasize responsiveness and coordination (such
as differentiation and integration) in vertical rela-
tionships, we propose to complement the rich
body of research that has focused primarily on
the governance attributes of such relationships.
We also extend prior research that has used the
differentiation and integration constructs primarily
to study the adaptive capacity of the internal
Copyright  2005 John Wiley & Sons, Ltd.
Adaptation in Vertical Relationships 417
organization of firms, by applying these con-
structs to the context of vertical relationships.
In developing our theory, we will argue that
different modes of organizing vertical relation-
ships—internal procurement, market procurement,
and alliances—vary systematically in the extent
of differentiation and integration between supply-
ing and procuring units. As a result, they vary
in terms of their adaptive capacity: their capac-
ity to respond in a coordinated and cooperative
manner to changes in exchange conditions. These
differences are reflected in performance differences
across modes of procurement that face differing
levels of adaptation pressures in the transaction and
task environments. Those instances in which the
adaptive capacity of the procurement arrangement
matches the adaptation pressures faced perform
better than those without such a match.
THE ADAPTIVE CAPACITY OF
VERTICAL RELATIONSHIPS
In most prior research on the delineation of firm
boundaries, scholars have studied two different
modes of organizing vertical relationships: firms
can either ‘make’ (procure from an internal sup-
plying unit within the firm) or ‘buy’ each compo-
nent (from an external supplier outside the firm)
necessary to complete their chosen product man-
dates (Coase, 1937; Williamson, 1975). In recent
years, scholars have expanded this dichotomous
choice to focus on other ‘hybrid’ forms of orga-
nization that are intermediate between make and
buy (Bradach and Eccles, 1989; Dyer and Singh,
1998; Gulati, 1998; Helper et al., 2000; Poppo and
Zenger, 2002; Williamson, 1991a; Zaheer, 1995).
In this study, in addition to make and buy, we focus
on vertical alliances (or ‘ally’), a hybrid form that
indicates a relationship characterized by continuity
between two independent firms operating at suc-
cessive stages in a vertical chain of production,
with both firms expecting the interaction to con-
tinue into the future (Heide and John, 1990). As
opposed to arm’s-length exchanges, which tend to
be on the open market, discrete, and short term,
vertical alliances tend to have a long time horizon
or to be open ended (Ring and Van de Ven, 1992,
1994). Since the exchange partners are ultimately
not under the same legal ownership structure,
however, the supplying and purchasing units retain
Strat. Mgmt. J., 26: 415–440 (2005)
418 R. Gulati, P. R. Lawrence and P. Puranam
autonomy in decision making and rights over resid-
ual returns (Grossman and Hart, 1986).
Our unit of analysis for this study is the
vertical relationship that a firm undertakes for
the procurement of a component. We treat
each relationship as akin to two interacting
subunits of an organization: the procuring and
supplying units. The two units could be part
of the same firm (internal procurement or
‘make’), or belong to different firms but are
tied together by ongoing exchange (vertical
alliances or ‘ally’) or arm’s-length contracting
(market contracting, or ‘buy’). We propose
that vertical relationships are characterized by
varying levels of adaptive capacity as indicated
by the associated levels of differentiation and
integration between the procuring and supplying
unit. The adaptive capacity of the relationship
impacts its performance, conditional on contextual
attributes associated with the exchange. We first
describe how different modes of organizing
vertical relationships—make, buy, ally—differ
from each other in the extent of integration and
differentiation, and then discuss the consequence
of these differences for the performance of the
vertical relationship.
Differentiation in vertical relationships
Differentiation is the ‘state of segmentation of
the organizational system into subsystems, each
of which tends to develop particular attributes
in relation to the requirements posed by its
relevant external environment’ (Lawrence and
Lorsch, 1967b: 4). It refers to the degree to which
organizational units have developed distinctive
structural characteristics and their members
have made behavioral accommodations to their
environment. It thus captures organizational
differences across the procuring and supplying
organizational subunits as a consequence of
specialization and local adaptation, and it
results in organizational diversity. The concept
encompasses not only the differentiation of formal
structure and accompanying specialization but also
differentiation in the behavioral and attitudinal
attributes of members of units (Lawrence and
Lorsch, 1967a, 1967b). The key dimensions along
which the differentiation of subunits can be
assessed include differences in (1) the degree of
formal structure, (2) the interpersonal orientation
of members, (3) the time horizon of members, and
Copyright  2005 John Wiley & Sons, Ltd.
(4) the goals of members (Lawrence and Lorsch,
1967b; Dougherty, 2001).
In vertical relationships, supplying units are
likely to be more differentiated from procuring
units if they do not belong to the same firm,
as there are limits on the extent to which
organizational units within a firm can become
differentiated from each other. An enduring pattern
of behavior in organizations is the tendency to
enforce conformity, treating all units alike so that,
regardless of their task, they will tend to share
a culture, business systems, and human resource
policies. The pressures toward conformity emanate
from several sources: (1) inter-unit rivalry, driving
a desire to be treated the same as everyone
else (Bradach and Eccles, 1989); (2) the physical
and administrative proximity of units, facilitating
social comparison processes (Zenger and Hesterly,
1997); (3) the need to facilitate career paths across
units; and (4) the need to simplify the management
tasks facing corporate executives responsible for
multiple units. In addition to conformity pressures,
the career advancement systems in hierarchies,
which favor generalists over specialists, can limit
the degree of differentiation possible. In contrast,
supplying units outside the firm are unlikely to
face pressures toward conformity with each other,
though they may face pressures to conform to
other units within their own firms. We therefore
expect that in vertical relationships the extent
to which procuring and supplying units are
organizationally differentiated from each other
varies with the fact of their joint memberships
in a firm. When they belong to different firms,
we should expect greater differentiation between
them than when they are in the same firm. We
predict:
Hypothesis 1: Supplying units will be more
differentiated from procuring units in market
procurement and vertical alliances, than in
internal procurement.
Integration in vertical relationships
Integration is the ‘quality of the state of
collaboration that exists among departments that
are required to achieve unity of effort by the
demands of the environment’ (Lawrence and
Lorsch, 1967a: 11). While traditionally applied
to departments within a firm, the notion of
integration can also be used to understand
Strat. Mgmt. J., 26: 415–440 (2005)

relationships between organizational units from
different firms. Integration not only requires the
alignment of interests (cooperation), but also
the alignment of actions (coordination). The
distinction between cooperation and coordination
is seldom maintained in organizational research.
This is despite periodic recognition by scholars
of important differences between the two (Grant,
1996; Heath and Staudenmayer, 2000; Jacobides,
2005; Kogut and Zander, 1996; Simon, 1991).
We explain this difference in some detail
below in order to support the point that
integration encompasses both cooperation and
coordination.
Integration as cooperation and coordination
Problems of cooperation arise from conflicts of
interest. Under assumptions of self-interest, or its
stronger forms (such as opportunism), collectively
beneficial outcomes fail to arise due to actions
motivated by the private benefits to individuals.
The canonical problem is the famous prisoner’s
dilemma. Problems of hold-up, agency, and the
tragedy of the commons are all variants on the
prisoner’s dilemma (Camerer and Knez, 1996,
1997; Foss, 2001; Heath and Staudenmayer, 2000).
In essence, the problem of cooperation is a
problem of motivation. It is resolved by aligning
interests through formal mechanisms such as
contracting (where possible) (Williamson, 1975),
common ownership of assets (Grossman and
Hart, 1986; Hart, 1995), monitoring, sanctions
(Williamson, 1985), and the prospect of future
interactions (Baker et al., 2002; Heide and Miner,
1992). Informal mechanisms such as identification
and embeddedness may also serve to align
interests (Granovetter, 1985; Gulati, 1995a, 1995b;
Gulati and Sytch, 2005; Kogut and Zander,
1996).
In contrast, coordination problems arise due
to the lack of shared and accurate knowledge
about the decision rules that others are likely to
use and how one’s own actions are interdepen-
dent with those of others (Geanakoplos, 1992;
Malmgren, 1961; Milgrom and Roberts, 1992;
Thompson, 1967). The experimental economics
literature on ‘weakest link’ games illustrates
coordination failures due to lack of knowl-
edge of how others will act. These games
show that uncertainty about others’ rationality
Copyright  2005 John Wiley & Sons, Ltd.
Adaptation in Vertical Relationships 419
can be a key constraint on successful coor-
dination on an efficient equilibrium (Camerer
and Knez, 1997; Gulati et al., 1994; Knez and
Camerer, 1994, 2000; Van Huyck et al., 1990,
1991).
Behavioral economists have also modeled
coordination problems where the agents are
unaware of how their actions are interdependent,
but discover them through an iterative, bounded
rational learning process (Camerer, 2003). The
organizational literature on adaptation on rugged
landscapes (Kauffman, 1993) addresses similar
problems. Myopic agents discover the true
nature of their interdependence through search
processes of varying degrees of intelligence
(Ethiraj and Levinthal, 2004; Gavetti and
Levinthal, 2000; Levinthal and Warglien, 1999;
Rivkin and Siggelkow, 2003; Siggelkow and
Levinthal, 2003). While formal analysis of
coordination is relatively new in the economics and
organizational literature, classical discussions of
interdependence and coordination in organization
theory were closely linked to the problem of
creating knowledge about others’ actions and
interdependence of actions (e.g., March and
Simon, 1958; Thompson, 1967). In this literature,
organizing to achieve coordination relied on three
broad categories of mechanisms: programming,
hierarchy, and feedback—each of which served
to enhance the predictability of other’s actions,
and to increase knowledge about how actions
are interdependent (Galbraith, 1977; Nadler and
Tushman, 1998; Thompson, 1967; Tushman and
Nadler, 1978).
In sum, coordination problems refer to the dif-
ficulties of aligning actions. They can persist
even when interests are aligned, i.e., when coop-
eration is achieved. Put more strongly, incen-
tives, sanctions, monitoring, rewards, and punish-
ments can help to achieve cooperation but are
not sufficient to achieve coordination (Gulati and
Singh, 1998). This is because cooperation prob-
lems are rooted in motivation, whereas coordi-
nation problems arise due to the cognitive lim-
itations of individuals that deny them compre-
hensive knowledge of how others will behave
in situations of interdependence, and how they are
interdependent with others. Therefore, the achieve-
ment of integration—‘unity of effort’ in Lawrence
and Lorsch’s terms (1967a, 1967b)—requires the
resolution of both cooperation and coordination
problems.
Strat. Mgmt. J., 26: 415–440 (2005)
420 R. Gulati, P. R. Lawrence and P. Puranam
Integration in make, ally and buy
In this section, we will argue that the extent of
integration between procuring and supplying units
varies systematically across different modes of
procurement, as these modes differ in the mecha-
nisms available to generate cooperation and coor-
dination.
Cooperation between organizational units can
arise when there are appropriate formal and infor-
mal incentives. For instance, the use of bonuses
tied to firm-level profits can create incentives for
cooperative behavior across departments (Gupta
and Govindarajan, 1986; Kretschmer and Puranam,
2004). Cooperation can also arise through pro-
cesses of identification, which infuse members of
organizational subunits with a willingness to coop-
erate and exert effort for the goals of the aggre-
gate organization (Barnard, 1938; Ghoshal and
Moran, 1996; Lawrence and Lorsch, 1967b). In the
context of vertical relationships, transaction cost
economists have argued that cooperation between
procuring and supplying units is likely to be higher
when they both belong to the same firm. Within
a firm, formal mechanisms such as authority and
incentives influence cooperation between organi-
zational units, aided by the continuity of associ-
ation that common membership in a firm entails
(Williamson, 1985).
The quality of coordination between procuring
and supplier units is also expected to be superior
when they belong to the same firm. While gover-
nance is often construed as a set of mechanisms
that facilitate cooperation (such as fiat, sanctions,
and monitoring), it also represents a collection
of coordination mechanisms (Gulati and Singh,
1998). Within firms, coordination between units
is aided by the possibility of centralized decision
making and the authority to design and use modes
of coordination such as programming, hierarchy,
and feedback (March and Simon, 1958; Thompson,
1967; Galbraith, 1977). Programming involves
prior agreement on what actions must be taken and
when (e.g., standards, schedules), and therefore
enables coordination by enhancing the predictabil-
ity of others’ actions. When programming proves
insufficient, hierarchical elements such as a single
source of authority and centralized decision mak-
ing can enable coordination by dedicating individ-
uals to the task of coordination, and allowing them
to be informed about and even decide how differ-
ent interdependent actors should behave. When it
Copyright  2005 John Wiley & Sons, Ltd.
is important to be informed of others’ actions on an
ongoing basis, or when the nature of interdepen-
dence must be discovered in an iterative fashion,
then mechanisms that provide feedback (such as
co-location and teams) enable mutual adjustment
on an ongoing basis (Thompson, 1967; Van de Ven
and Delbecq, 1974).
In addition to the formal mechanisms of coor-
dination, a number of elements of informal orga-
nization, such as shared experience, culture, lead-
ership, norms, and precedent increase confidence
about how others will behave and how one should
behave in a given situation, and so enable coor-
dination. The accumulation of shared experience
and continuity of association is likely to be strong
within firms, as its boundaries dictate who interacts
with whom on a regular basis and often imply spa-
tial collocation. Thus, co-membership within a firm
can lead to the creation of shared understanding of
the task environment and the interdependence it
embodies (Weick, 1993, 1995) as well as shared
values and norms that serve to make the actions of
others more predictable (Kogut and Zander, 1996).
Such formal and informal mechanisms that aid
coordination are typically unavailable in arm’s-
length relationships characteristic of market pro-
curement. Without common ownership, the design
and implementation of coordination mechanisms to
link the procuring and supplying units can involve
costly and time-consuming negotiations even in
the absence of opportunism (Conner and Praha-
lad, 1996; Hart, 1995). The low expected fre-
quency of future exchanges in arm’s-length con-
tracting may also make it harder to amortize the
fixed costs of setting up such coordination struc-
tures (Dyer and Singh, 1998; Helper et al., 2000).
The brevity of the relationship also implies a
lack of time for partners to learn one another’s
ways of doing business and develop multiple com-
munication links or shared norms, values and
beliefs. Further, differentiation itself may act as an
impediment to integration (Lawrence and Lorsch,
1967a, 1967b). Differentiated organizational units
that have cognitive and emotive differences (and
therefore, unknown differences in decision rules
and understanding of interdependence) may find it
harder to achieve coordination than undifferenti-
ated units (Dougherty, 2001). As we have argued
earlier (Hypothesis 1), external procurement is
characterized by higher levels of differentiation,
and so may face greater challenges in achieving
integration. These factors conspire to make it hard
Strat. Mgmt. J., 26: 415–440 (2005)

to achieve the same degree of close coordination
between procuring and supplying units in market
procurement as in internal procurement.
Vertical alliances can approximate some of
the features of internal procurement in terms of
coordination and cooperation. Long-term alliances
can generate a state of cooperation between
partners due to the ‘shadow of the future’
(Axelrod, 1984). With each partner anticipating
doing business with the other well into the
future, cooperation between them is more likely.
Each sees the benefits from future interactions
as outweighing the immediate pay-offs from non-
cooperative behavior and thus may choose to
cooperate (Baker et al., 2002). The influence of
such a time horizon on cooperative behavior
has been observed in a variety of settings
ranging from laboratory experiments (Murnighan
and Roth, 1983) to firm–union relationships (Das
and Teng, 1998). In addition to the assurance
effects that arise in repeated interactions, trust
between partners may also develop over time as a
consequence of opportunities to share information
and learn about each partner’s proclivities toward
trustworthy behavior (Gulati, 1995a, 1995b, 1998).
While these forms of relational contracting may
provide collaborative effects weaker than those in
ownership, which has the advantages of absolute
authority and complete discretion to modify
incentives, they may nonetheless be significant.
Alliances may also benefit from mechanisms
of coordination unavailable in market procure-
ment (Bensaou and Venkatraman, 1995; Gulati
and Singh, 1998). Repeated interactions between
partner firms may justify investments in mech-
anisms of coordination, such as inter-firm orga-
nizational structures and information technology
integration (Zaheer and Venkatraman, 1994), and
may also give rise to a superior capacity for coor-
dinating with each other through the formation of
inter-firm routines (Dyer and Singh, 1998). Such
routines embody knowledge about how coordi-
nating agents will behave. Frequent and contin-
ued contact between the personnel of procuring
and supplying units may also enable the forma-
tion of shared representations of the task envi-
ronment, also enhancing coordination. Thus, inter-
nal procurement and vertical alliances have access
to enablers of integration between units that are
unavailable in arm’s-length transactions. We there-
fore expect:
Copyright  2005 John Wiley & Sons, Ltd.
Adaptation in Vertical Relationships 421
Hypothesis 2: Supplying units will be more
integrated with procuring units in internal
procurement and vertical alliances, than in
market procurement.
We can summarize the relationships between the
three modes of organizing vertical relationships
as follows: Internal procurement is characterized
by weak differentiation and strong integration
between procuring and supplying units. Market
procurement is characterized by weak integration
and strong differentiation between procuring
and supplying units. Vertical alliances may
provide more balanced levels of integration and
differentiation. This is because vertical alliances
provide more integration than market procurement
and more differentiation than internal procurement
(see Figure 1).
The adaptive benefits of integration and
differentiation in vertical relationships
We now turn to the effects of differentiation and
integration in coping with the adaptation pressures
that arise in vertical relationships to procure dif-
ferent kinds of components. We analyze two basic
categories of adaptation pressures: (a) changes
in the transaction environment for the compo-
nent—due to fluctuations in demand, supply, or
technology; and (b) the need for mutual adjustment
in the task environment associated with the com-
ponent—due to strong interdependencies between
the activities of the supplier and buyer. We argue
below that, on the one hand, these two factors
together influence the magnitude of adaptation
requirements in a given vertical exchange. On
the other hand, the extent of differentiation and
integration between supplying and procuring units
Differentiation
Integration
Make Ally Buy
Figure 1. Differentiation and integration in vertical
relationships
Strat. Mgmt. J., 26: 415–440 (2005)
422 R. Gulati, P. R. Lawrence and P. Puranam
impacts the adaptive capacity of the vertical rela-
tionship. The match between adaptive capacity
and adaptation requirements influences the perfor-
mance of the relationship.
Effects of adaptation pressures in transaction
environment
The transaction environment in vertical relation-
ships refers to the set of commercial contingencies
(such as demand, supply, and technology con-
ditions) that influence the terms and content of
the transaction (Williamson, 1985, 1991a, 1991b).
Adaptation pressures arise in the transaction envi-
ronment when these attributes of the transaction
change. We define ‘transaction instability’ as the
extent and rate of change in demand and technol-
ogy relevant to a particular transaction.2 For the
vertical relationship to continue in a fruitful man-
ner, such changes must first of all be recognized,
and then adapted to. Ambiguity and lack of the
information about changes in the transaction envi-
ronment may make responsiveness difficult (Daft
and Lengel, 1986).
Differentiation between the supplying and
procuring units contributes to the adaptive
capacity of a vertical relationship under conditions
of transaction instability by enhancing its
responsiveness to such changes in two ways.
First, differentiation can help create ‘requisite
variety’ (Ashby, 1968), as a collection of
subunits of an organization that are diverse in
terms of organizational attributes is more likely
to include at least one subunit that closely
matches environmental contingencies (Lawrence
and Lorsch, 1967a, 1967b). Cohen and Levinthal
in their discussion of organizational absorptive
capacity make a similar point: under conditions
of rapid and uncertain change, they claim that it is
best for the organization to ‘expose a fairly broad
range of ‘receptors’ to the environment’ (Cohen
and Levinthal, 1990: 132).
Second, differentiation can enable parallel and
therefore broad-ranging search for new oppor-
tunities that emerge due to changed conditions.
2
Instability is distinct from complexity, which refers to the
heterogeneity or diversity in key exogenous characteristics
relevant to an organizational unit (Thompson, 1967; Lawrence
and Lorsch, 1967a, 1967b). Instability and complexity together
form key dimensions of uncertainty as conceptualized by
organization theorists (Daft, 2001). Given our focus on
adaptation, we restrict our attention to instability, as complexity
is a static aspect of the organizational environment.
Copyright  2005 John Wiley & Sons, Ltd.
Using simulations of organizational adaptation on
rugged landscapes, several scholars have noted
that internally differentiated organizational struc-
tures can benefit from parallel exploration (Rivkin
and Siggelkow, 2003; Ethiraj and Levinthal, 2004;
Siggelkow and Levinthal, 2003). This is because
the search processes of differentiated organiza-
tional subunits are themselves likely to differ in
terms of objectives, heuristics, and learning pro-
cesses. The parallel operation of different search
processes by organizational subunits effectively
expands the search scope of the parent organiza-
tion.
Through requisite variety and parallelism,
differentiation creates adaptive capacity in vertical
relationships by making them sensitive to changes
in the transaction environment. This capacity
to sense and respond is valuable when the
transaction environment is unstable (Dess and
Beard, 1984; Duncan, 1972; Mintzberg, 1979).
Transaction instability can adversely affect the
performance of vertical relationships, though the
magnitude of the effect will depend on the
capacity of the relationship to adapt to transaction
instability. Under the principle of ‘fit’ between the
adaptive capacity of a vertical relationship and the
pressures towards adaptation it faces, we expect
that the performance of modes of procurement
characterized by a low degree of differentiation
between procuring and supplying units is likely
to be most adversely affected by transaction
instability. Since internal procurement offers the
least scope for differentiation between procurer
and supplier (Hypothesis 1), its performance
should be significantly depressed relative to
other modes of procurement under conditions of
transaction instability. We therefore expect:
Hypothesis 3: Transaction instability has more
adverse effects on the performance of internal
procurement than on the performance of market
procurement and vertical alliances.
Effects of adaptation pressures in task
environment
The task environment in vertical relationships
refers to the division of labor across the value chain
and the ongoing pattern of interactions between
upstream and downstream activities (Bensaou and
Venkatraman, 1995; Gulati and Singh, 1998).
Interdependence across organizational subunits
Strat. Mgmt. J., 26: 415–440 (2005)

is an important source of adaptation pressures
within the task environment (Van de Ven and
Delbecq, 1974). Two activities may be said to
be interdependent when the value of performing
one activity depends on how the second
activity is performed (Milgrom and Roberts,
1990, 1995; Thompson, 1967). In Thompson’s
classic typology, the nature of interdependence
is relatively well known in situations he referred
to as ‘pooled’ and ‘sequential’ interdependence.
Interdependence is ‘pooled’ when tasks depend
on each other in a simple additive manner; each
task renders a discrete contribution to the whole,
and each is supported by the whole (Thompson,
1967: 54, 64). Interdependence is ‘sequential’
when the outputs of one task form the inputs of the
other. Achieving maximum combined value across
activities in these two cases requires that each task
be performed essentially independently (but in the
proper sequence) as well as it can be.
The situation is more complicated when the
true nature of interdependence between tasks is
unknown ex ante, or if ongoing communication
is necessary to create awareness about others’
actions. Thompson referred to such situations
as ‘reciprocal’ interdependence. In this case,
the nature of interdependence implies a state
of continuous adaptation between units as
ongoing decision making about task allocation
(i.e., planning) and continuous communication
(i.e., mutual adjustment) is required (Thompson,
1967: 54–55, 64). In addition to coordination
problems, reciprocal interdependence can also
create significant cooperation problems because
of the dangers of free-riding (Petersen, 1992;
Wageman and Baker, 1997). When several
individuals must contribute to a task, but it is
hard to verify their marginal contributions, then
collective under-investment of effort may occur
(Alchian and Demsetz, 1972; Holmstrom, 1982).
Thus, reciprocal task interdependence can create
significant cooperation and coordination problems.
In vertical relationships, reciprocal interdepen-
dence can arise when the design and production of
the procured item require significant levels of joint
activity by the buyer and supplier. This can involve
extensive interactions between the two for the sup-
plier to understand and meet the specific require-
ments of the buyer, as well as ongoing interac-
tions as the supplier fulfills the procurement order.
Unlike the case when designs can be ‘tossed over
the wall’ from the buyer to the supplier, reciprocal
Copyright  2005 John Wiley & Sons, Ltd.
Adaptation in Vertical Relationships 423
interdependence requires continuous adaptation in
the vertical relationships as both parties engage in
joint problem solving (Iansiti, 1998; Monteverde,
1995). Integration between units enables them
to manage reciprocal interdependence effectively
(Thompson, 1967; Lawrence and Lorsch, 1967a,
1967b). Formal mechanisms such as incentives
and information-processing structures, and infor-
mal elements such as identification and culture,
ensure that adaptation by the procuring and sup-
plying unit takes place in a cooperative and coor-
dinated manner. We therefore expect the perfor-
mance of procurement modes that are character-
ized by low degrees of integration to be most
adversely affected by task interdependence. Since
market procurement has the least capacity for
achieving integration between supplier and pro-
curer (Hypothesis 2), we expect:
Hypothesis 4: Reciprocal task interdependence
has more adverse effects on the performance of
market procurement than on the performance of
internal procurement or vertical alliances.
Joint effects of adaptation pressures in transaction
and task environment
Our last hypothesis pertains to the joint effects
of transaction instability and task interdependence
on the performance of vertical relationships. We
expect that task interdependence and transaction
instability have superadditive effects on the
need for adaptation in vertical relationships—put
differently, we expect interdependence to magnify
the effect of instability on the need for
adaptation and vice versa. Transaction instability
requires adaptation through search for solutions
to the contractual difficulties posed by changes
in technology or market conditions. However,
interdependence imposes constraints on that
search process, as successful adoption of the
new solution will require coordinated action by
procurer and supplier. Therefore, interdependence
makes adaptation to instability more difficult. In
the absence of interdependence, the search for
and adoption of new solutions is a unilateral
affair. Conversely, task interdependence requires
ongoing coordination and mutual adjustment
between procurer and supplier units as they
engage in their respective activities. Instability
in transaction conditions magnifies the extent of
mutual adjustment required, as the procurer and
Strat. Mgmt. J., 26: 415–440 (2005)
424 R. Gulati, P. R. Lawrence and P. Puranam
supplier need to adapt not only to the consequences
of each other’s ordinary activities due to
interdependence, but also extraordinary changes
due to instability. In the absence of instability,
mutual adjustment due to interdependence is a
‘routine’ affair (Nelson and Winter, 1982).
There are important performance consequences
of the superadditive joint effects of transaction
instability and task interdependence. Modes of pro-
curement that are able to adapt in some degree to
both instability and interdependence suffer lower
performance penalties from their joint effects,
compared to modes that specialize in adaptation
to any one. This suggests the existence of comple-
mentarities between differentiation and integration
when there are significant adaptation pressures in
both the task and transaction environment. For
instance, under conditions of high task interde-
pendence and transaction instability, neither differ-
entiation nor integration alone provides adequate
adaptive capacity. Instead, some combination of
the two is required. Recent studies using agent-
based simulation models (Rivkin and Siggelkow,
2003; Siggelkow and Levinthal, 2003) also high-
light the complementarities between organizational
mechanisms that enable parallel search (such as a
differentiated organizational subunits engaged in
parallel search processes) and the coordination of
interactions between agents engaged in parallel
search (for instance through an integrated evalu-
ation of the alternatives they generate).
The unique organizational position occupied
by vertical alliances arises from their ability
to generate greater differentiation than internal
procurement and greater integration than market
procurement (Hypotheses 1 and 2). Thus, unlike
internal procurement or market procurement,
the adaptive capacity of vertical alliances
is evenly based on both differentiation and
integration, whereas the adaptive capacity of
internal procurement is based primarily on
integration, and that of market procurement
is based primarily on differentiation. This
suggests that vertical alliances will have superior
adaptive capacity compared to internal or
market procurement, when both instability and
interdependence are present. We therefore predict:
Hypothesis 5: The joint effects of transaction
instability and reciprocal task interdependence
on the performance of vertical alliances will
Copyright  2005 John Wiley & Sons, Ltd.
be less adverse than that on other modes of
procurement.
METHODS
Sample and data collection
We utilize a survey of lead buyers of a variety
of component areas at the Ford Motor Company
and at the Chrysler Corporation conducted in
1995. Drawing on a previous study of the
automobile sector (Monteverde and Teece, 1982)
and our discussions with informants in the
automobile industry, we developed a list of 120
components that go into most automobiles. The
comprehensiveness of this list was verified with
several executives in the industry and was also
compared against component lists used by the
firms to monitor their own parts quality. In-depth
interviews with managers at Ford Motor Company
and Chrysler Corporation preceded the design of
the questionnaire and influenced many of the items
included. We conducted a total of 37 interviews (16
at Chrysler; 21 at Ford). We ensured that we spoke
with managers responsible for both external and
internal sourcing. These included individuals in
purchasing, quality control, platform management,
and engineering operations. The initial interviews
were exploratory and open ended but focused on
the characteristics of each individual’s particular
component, the type of sourcing arrangement and
supplier used, its relative performance, and the
pros and cons of alternative sourcing arrangements
for that component. In later interviews, we
sought clarifications on key constructs for
this study, including transaction instability, task
interdependence, differentiation, integration, and
performance.
The survey instrument was designed on the basis
of these interviews and items from prior studies
on vertical relationships. The survey was thor-
oughly pretested with several groups of senior
managers at the participating companies to remove
ambiguities and examine the face validity of our
measures. Three groups of five executives each
at the two companies went through the survey
together to identify questions that were unclear or
subject to multiple interpretations, revealed sensi-
tive information, were difficult to answer, or were
subject to social desirability bias. We incorpo-
rated the detailed feedback from these groups and
Strat. Mgmt. J., 26: 415–440 (2005)

then sought additional input on the revised instru-
ment from them to make additional changes. To
reduce response bias, we also scattered questions
measuring each construct across the survey and
used multiple response formats.
For each component, senior managers at Ford
and Chrysler provided us with the names of indi-
viduals with oversight over the sourcing of that
component. We mailed our survey to these individ-
uals.3 Each survey respondent provided data on the
component he or she was in charge of sourcing, as
well as data on the two largest suppliers (or one, if
only one existed) for that component. Unlike prior
studies that aggregate all transactions relevant to a
particular component (e.g., Monteverde and Teece,
1982), our analysis is truly at the transaction level.
We ensured that each survey respondent was the
expert for a given component by verifying his or
her expert status with the controller’s office in each
company. Our cover letter to respondents indicated
that they had been identified as an expert on the
acquisition of a given component and asked for the
return of the uncompleted survey and a nomination
of an expert if this were not the case.
Survey implementation took several standard
steps to ensure a good response rate. Sixty-four
executives responded from Ford, and 67 executives
responded from Chrysler, representing response
rates of 53 percent and 56 percent, respectively,
and a total response rate of 55 percent. We obtained
data usable for this study on 222 procurement
relationships, though data limitations reduced the
effective number of observations for some multi-
variate analyses. We checked for non-response bias
by comparing the characteristics of the components
for which we received responses against those for
which we did not receive a response. For each
company, we assessed whether the components in
our sample differed significantly from those which
were not in our sample, on two key characteristics
of components identified in prior research: type
of sourcing and engineering complexity. We relied
on Monteverde and Teece’s (1982) ratings of the
primary types of sourcing of all components in
automobiles and ratings of their engineering com-
plexity as a basis for this comparison. We used the
Kolmogorov–Smirnov two-sample test to assess
the possibility of differences in the distribution of
components in and outside the sample across these
3
Respondents were distinct from the senior managers who
helped in pretesting the survey.
Copyright  2005 John Wiley & Sons, Ltd.
Adaptation in Vertical Relationships 425
two variables (Siegel, 1956). The results of this test
indicate that sample selection bias is not an issue
with these data.
Measures
Each respondent was asked to answer some general
questions about the exchange conditions relevant
to his or her component. The respondent then iden-
tified the two principal suppliers of that component
and answered a detailed set of identical questions
about each of them. We used multi-item forma-
tive scales for most of our constructs. The items
were based on a survey of the literature as well as
fieldwork and the pretests. The key variables used
in the analysis are reported in Table 1, along with
details of the items used to construct them.
Procurement mode
The procurement mode is the specific organiza-
tional arrangement used to procure a component.
Respondents identified each of two primary sup-
ply relationships for the component as falling into
one of three categories defined in the question-
naire: (a) purchasing arrangement with external
suppliers characterized by relatively shorter-term
contracts and competitive bidding (market pro-
curement); (b) purchasing arrangement with exter-
nal supplier characterized by relatively longer-
term or open-ended contracts (vertical alliance);
and (c) purchasing arrangement with an internal
division of their company (internal procurement).
The response to this question was corroborated
with two other survey items in which respondents
indicated the percentage of the given component
sourced through each of the three types of arrange-
ments, and the expected duration of each relation-
ship. Of the 222 exchanges in our sample, 21 were
organized as internal procurement, 132 were orga-
nized as vertical alliances, and 69 were organized
as market procurement.
Differentiation
Eight survey items were used to measure the
degree of differentiation of the supplier of a
component vis-à-vis the procurer. The dimensions
for this construct capture both structural and
behavioral elements and measure the difference
between supplier and procurer organizations in
terms of speed of decision making, flexibility,
Strat. Mgmt. J., 26: 415–440 (2005)
426 R. Gulati, P. R. Lawrence and P. Puranam
Table 1. Key constructs

Construct Items

Differentiation Difference in the scores assigned to procurer and supplier on following organizational
attributes:
1. Decision making (1 = quick, 7 = slow)
2. Culture (1 = rigid, 7 = flexible)
3. Information systems (1 = clear, 7 = complicated)
4. Time orientation (1 = long term, 7 = short term)
5. Style (1 = informal, 7 = formal)
6. Procedures (1 = bureaucratic, 7 = streamlined)
7. Employee benefits (1 = generous, 7 = limited)
8. Pay scales (1 = high, 7 = low)
Integration 1. This supplier has adapted its organization and management methods to work effectively
with your organization (1 = strongly disagree, 7 = strongly agree)
2. During the past year, how often were there significant disagreements between your business
unit and this supplier? (1 = very rarely, 7 = very frequently) [reverse coded]
3. How easy are the negotiations between your business unit and this supplier over sharing the
burden of cost when your business unit requests engineering changes? (1 = very easy,
7 = very difficult) [reverse coded]
4. How easy are the negotiations between your business unit and this supplier over sharing the
burden of cost when the supplier’s raw material costs increase (1 = very easy, 7 = very
difficult) [reverse coded]
5. Problems that arise in the course of this relationship are treated as joint rather than
individual responsibilities (1 = strongly disagree, 7 = strongly agree)
Reciprocal task Please indicate your opinion about the nature of the component (Scale: 1 = strongly disagree,
interdependence 7 = strongly agree)
1. Its design requires contributions from both parties
2. Its production requires ongoing contributions from both parties
3. It takes significant amount of time and effort to understand your company’s specific
requirements for this component
4. A significant amount of engineering effort is required in designing and developing this
component
5. Producing this component generates specialized expertise in the producer
Transaction Please indicate your opinion about the nature of the component (Scale: 1 = strongly disagree,
instability 7 = strongly agree)
1. Significant future technological improvements are expected in its design
2. There is significant unpredictability or technological shifts in its production process
3. Significant fluctuations are expected in its monthly volume requirements
4. There is significant uncertainty in its annual volume estimates
Performance of Your opinion about the attractiveness of this supplier compared to the best alternative supplier
vertical for this component
relationship 1. Price competitive (Scale: 1 = much less attractive than alternative, 7 = much more attractive
than alternative)
2. Support and services
3. Flexibility in production
4. Product quality
5. Product innovations
6. Overall performance

information systems, time horizon, formalization, Integration

bureaucratization, employee benefits, and pay
scales (Lawrence and Lorsch, 1967a, 1967b). The
Cronbach alpha measure for reliability for this
construct is satisfactory (0.78). Confirmatory factor
analysis yielded an adjusted goodness of fit index
of 0.94.
Copyright  2005 John Wiley & Sons, Ltd.
Five survey items captured the degree to which
a state of cooperation and coordination existed
between the supplying and procuring unit for each
component and were used to compute a single
scale for integration (Lawrence and Lorsch, 1967a,
Strat. Mgmt. J., 26: 415–440 (2005)

1967b). The Cronbach alpha measure of reliabil-
ity for this construct was 0.72, and the adjusted
goodness of fit index from confirmatory factor
analysis was 0.98.
Transaction instability
The instability in exchange conditions associated
with each component was broadly assessed in
terms of demand and technological developments.
These encompass measures of volume uncertainty
and technological uncertainty (Heide and John,
1990; Walker and Weber, 1984, 1987). To con-
struct the scale, we used four items. The reliability
of the scale was satisfactory (alpha = 0.73) and the
adjusted goodness of fit index from confirmatory
factor analysis was 0.99.
Reciprocal task interdependence
We used a scale constructed from five items
to measure the nature of task interdependence
between procurer and possible supplier for each
component. The items assessed the degree to
which simultaneous contributions from supplier
and procurer are required to design and produce
the component, as well as the need for extensive
interactions between the two for the supplier to
understand and meet the specific requirements of
the buyer (Thompson, 1967). The scale constructed
from these items had satisfactory reliability (alpha
= 0.71), and the adjusted goodness of fit index
from confirmatory factor analysis was 0.97.
Performance of vertical relationship
Objective data on exchange performance is con-
sidered confidential and is hard to collect. As a
result, we used items capturing multiple facets of
the satisfaction of the procurers with the supplier
in comparison with alternative suppliers. While we
recognize that the satisfaction of the procurer with
the supplier is not identical to exchange perfor-
mance, we expect that it should be strongly corre-
lated with it. We used six measures rating supplier
performance along the dimensions of price, inno-
vativeness, flexibility, and quality. The Cronbach
alpha for this scale was 0.89, and the adjusted
goodness of fit index from confirmatory factor
analysis is 0.91.
Copyright  2005 John Wiley & Sons, Ltd.
Adaptation in Vertical Relationships 427
Control variables
Several control variables that might impact the
dependent and independent variables were used
in the analysis. First, we controlled for assembler
differences by including a dummy variable to dif-
ferentiate Ford from Chrysler. Second, we limited
informant bias by including a variable to control
for the informant’s experience with the supplier
(Kumar et al., 1993; Phillips, 1981). This was
measured as the logarithm of the number of months
that the respondent had personally dealt with the
supplier. Third, we included a measure of the dura-
tion of the procuring relationship between the pro-
curer and supplier (Kotabe et al., 2003). This was
measured as the logarithm of the number of years
the assembler has purchased the component from
the supplier. Fourth, we controlled for supplier
and buyer asset specificity, which are important
alternative explanations from the transactions cost
perspective. These variables were measured using
single items, in which the respondent indicated
agreement with the following assertions: ‘This sup-
plier has made significant investments in terms
of equipment, facilities, and engineering designed
specifically to meet the buyer’s supply require-
ment for the component’ (supplier specificity) and
‘Your company has made significant investments
in tooling and equipment that are specific to your
relationship with the supplier’ (buyer specificity).
Finally, we controlled for the volume of transac-
tions for the component, as well as across all com-
ponents between the supplier and assembler firm.
These were categorical measures of the annual
dollar value of purchases from a supplier for the
focal exchange and from all exchanges between
the buyer and supplier, respectively. The bound-
aries of the qualitative categories are less than
$10 million, $50 million, $100 million, or more
than $100 million.
Analysis techniques
Hypotheses 1 and 2 predict differences in differ-
entiation and integration across the three modes
of procurement. We therefore used OLS regression
models to test them. To test Hypotheses 3, 4, and 5,
we need to assess the relative impact of transaction
instability, task interdependence, and their joint
effect on the performance of different modes of
procurement. Simply regressing the performance
of each procurement mode on indicator variables
Strat. Mgmt. J., 26: 415–440 (2005)
428 R. Gulati, P. R. Lawrence and P. Puranam
that classified that procurement relationship into
make, buy, and ally, along with interaction terms
with instability and interdependence, would not be
appropriate. Unobserved features of the exchange
(such as component, supplier, or procurer charac-
teristics) could simultaneously influence the choice
of procurement mode as well as performance out-
comes (Hamilton and Nickerson, 2003; Shaver,
1998). It would then be difficult to draw valid con-
clusions about the effect of instability and interde-
pendence on the performance of the mode of pro-
curement. We therefore used a switching regres-
sion model that attempts to account for possibly
endogenous choices of procurement modes. This
model is estimated in two stages. First, a multi-
nomial logit model is used to explain modes of
procurement. The estimates from this model are
used to calculate a non-selection hazard into each
mode of procurement for each observation, which
reflects the effect of unobservable variables that
influence the procurement mode decision. Second,
we estimate separate OLS regressions for subsam-
ples of observations on each procurement mode,
in which we include the non-selection hazard as a
control variable. By its inclusion, the non-selection
hazard controls for unobservable features of the
relationships that might simultaneously affect the
choice of mode and performance (Gulati and Nick-
erson, 2004; Poppo and Zenger, 1998; Shaver,
1998).
RESULTS
Table 2 reports the summary statistics and pair-
wise correlations between variables used in our
analysis. The largest correlation between two
independent variables is 0.66 (between component
procurement volume and total procurement
volume). Collinearity therefore does not appear
to be a significant concern. However, we
calculated the variation inflation factors for all
estimated models as a precaution, and these
were well within acceptable limits. Several pair-
wise correlations are significant at the 1 percent
level. For instance, integration is strongly
correlated with relationship performance. It is also
noteworthy that the correlations between reciprocal
interdependence and supplier and buyer specificity
are small (0.13 and 0.11), lending support to
our arguments that these are distinct constructs.
Supplier and buyer specificity themselves are
Copyright  2005 John Wiley & Sons, Ltd.
only correlated 0.22. Our interview data suggest
that in the automotive industry suppliers are
more likely to make specific investments than
assemblers.
Table 3 reports results from OLS models in
which the dependent variables are the extent of
differentiation and integration between procuring
and supplying units. For the specification in which
differentiation is the dependent variable (column
1), only 193 observations were available. We used
robust standard errors to calculate t-statistics in
order to minimize the effect of heteroscedastic-
ity. We tested Hypotheses 1 and 2 by introduc-
ing dummy variables for the mode by which the
procuring relationship was organized. We con-
trolled for assembler (Ford or Chrysler), buyer
experience with supplier, length of procuring rela-
tionship, and component and total volume of pro-
curement. Both models are significant, with R 2 of
12 percent and 8 percent. Examining the coeffi-
cients in column 1, we find that vertical alliances
and market procurement relationships are char-
acterized by greater differentiation than internal
procurement relationships (reference category). We
thus conclude that Hypothesis 1 is strongly sup-
ported. Vertical alliances and market procurement
do not appear to differ significantly in differen-
tiation. In column 2, the dependent variable is
integration and the reference category is mar-
ket procurement. We find evidence in favor of
Hypothesis 2, as internal procurement and verti-
cal alliances appear to be characterized by signifi-
cantly higher levels of integration between procur-
ing and supplying units than market procurement.
Thus, Hypothesis 2 is also supported. The coef-
ficient of internal procurement is larger and sta-
tistically different from that of vertical alliances.
Thus, vertical alliances appear to have differentia-
tion levels comparable to market procurement, and
integration levels lower than internal procurement.
Among the control variables, total volume of pro-
curement and the length of respondents’ business
association with the supplier (buyer history) have
negative effects on differentiation. This may be due
to convergence in organizational elements across
buyer and supplier due to extensive and lengthy
interactions. Procurement history has a negative
effect on integration. This may indicate the con-
straining effects of ties. Since tie duration is not
the focus of our analysis, we defer further investi-
gation of these results to future research.
Strat. Mgmt. J., 26: 415–440 (2005)
 Table 2. Descriptive statistics

Variable Obs. Mean S.D. Min. Max. 1 2 3 4 5 6 7 8 9 10 11 12 13

1 Differentiation 193 1.06 0.68 0.00 4.38 1

2 Integration 222 −0.18 1.39 −5.00 7.00 −0.16 1
3 Relationship 219 4.81 1.00 1.67 7.00 −0.06 0.25∗ 1

Copyright  2005 John Wiley & Sons, Ltd.

performance
4 Transaction 222 0.00 0.99 −2.36 3.14 −0.18∗ 0.02 −0.06 1
instability ∼
5 Reciprocal 222 0.00 0.80 −3.10 1.50 −0.23∗ −0.00 0.07 0.31∗ 1
interdependence
∼
6 Interdependence × 222 0.27 0.85 −2.13 4.71 0.02 0.01 0.14 0.28∗ −0.16 1
instability
7 Supplier asset 222 5.70 1.10 2.00 7.00 −0.15 0.11 0.28∗ 0.11 0.13 0.06 1
specificity
8 Buyer asset 222 4.74 1.68 1.00 7.00 0.03 0.01 0.00 0.13 0.11 −0.05 0.22∗ 1
specificity
9 Procurement history 222 2.45 0.77 0.00 4.32 −0.10 −0.17 −0.13 0.04 −0.11 0.04 −0.03 0.06 1
[ln(year)]
10 Buyer history 222 3.05 0.83 1.00 5.48 −0.14 −0.08 0.19∗ 0.13 0.06 0.09 0.11 0.11 0.11 1
[ln(months)]
11 Component 222 2.60 1.05 1.00 4.00 −0.08 0.04 −0.11 0.12 0.13 −0.03 0.03 0.11 0.21∗ 0 1
procurement
volume
12 Total procurement 222 3.21 1.00 1.00 4.00 −0.16 0.01 −0.06 0.01 0.15 −0.10 0.05 0.15 0.27∗ −0.01 0.66∗ 1
volume
13 Ford 222 0.55 0.50 0.00 1.00 −0.04 0.12 0.15 −0.14 0.22∗ 0.00 0.09 0.04 −0.14 0.33∗ −0.10 0.01 1
∗
14 Procurement mode 222 2.49 0.66 1.00 3.00 0.17 0.03 0.22 −0.06 −0.09 0.06 0.06 −0.21∗ −0.15 0.10 −0.12 0.01 0.18∗

∼ centered
∗
p < 0.01 in a two-tailed test
Adaptation in Vertical Relationships

Strat. Mgmt. J., 26: 415–440 (2005)

429
430 R. Gulati, P. R. Lawrence and P. Puranam
Table 3. Differences in organizational attributes across procurement mode, we assume that component and
procurement modes (OLS) total procurement volume do not directly affect
the performance of the procurement mode once
Differentiation Integration
we control for instability, interdependence, asset
Make 0.82∗∗ specificity, procurement, and buyer history and
0.38 assembler.5 Data limitations reduced the number
Buy 0.70∗∗∗ of observations at the first and second stage of
0.15 the analysis to 219 and 216 respectively.6 The
Ally 0.66∗∗∗ 0.35∗
0.14 0.19 results for the first-stage multinomial model are
Procurement history 0.05 −0.37∗∗ presented in Table 4. The model is significant, with
0.06 0.15 a pseudo-R 2 of 24 percent. The baseline category
Buyer history −0.13∗ −0.18 in Table 4 is vertical alliances (‘Ally’), so that the
0.07 0.14 coefficients must be interpreted as affecting the
Component volume 0.05 0.13
0.07 0.13
odds of choosing internal procurement (column
Total volume −0.12∗ −0.06 1) or market procurement (column 3), relative
0.07 0.105 to the odds of choosing alliances. We note
Ford −0.06 0.45∗∗ that our instrumental variables (component and
0.13 0.21 procurement volume) do affect procurement mode,
Constant 1.03∗∗∗ 0.61
0.39 0.41
as assumed. Across all three categories (make, buy,
and ally) component and procurement volume are
R2 0.12 0.08
F 5.84∗∗∗ 2.13∗∗ jointly significant at the 5 percent level.
n 193 222 While we use the results in Table 4 as
d.f. 7 7 an intermediate step in estimating a switching
regression model, these results are worth noting
∗
p < 0.10; ∗∗ p < 0.05; ∗∗∗ p < 0.01 in a two-tailed test. for their own merit. Reciprocal interdependence
Numbers below coefficients are robust standard errors. between supplier and procuring unit and buyer
asset specificity make internal procurement more
To test Hypotheses 3, 4, and 5, we used likely relative to alliances. Internal procurement
a switching regression model (Shaver, 1998; is also likely to have a longer history, and be
Hamilton and Nickerson, 2003). We estimate characterized by greater buyer asset specificity.
this model in two steps. First, we estimated a The coefficients in column 4 suggest that supplier
multinomial logit model to predict the choice asset specificity makes market procurement less
of procurement mode (make, buy, or ally).4 likely than alliances, but buyer asset specificity
In addition to transaction instability, reciprocal has the opposite effect. These results suggest
interdependence, and their interaction, which are that in the automotive industry, alliances are
the variables of theoretical interest, we controlled created to protect the idiosyncratic investments
for assembler (Ford or Chrysler), supplier, and of suppliers rather than buyers, whose position
buyer asset specificity, buyer experience with as monopsonists may allow them to use market
supplier, length of procuring relationship, and contracting with impunity. While not the focus
component and total volume of procurement. of our research, we believe that further analysis
Component and total procurement volume function of the distinct effects of buyer and supplier
as instrumental variables in our model, and do asset specificity may prove fruitful. Reciprocal
not appear in the second-stage models predicting interdependence appears to increase the odds of
performance. While they are expected to affect
5
Such an assumption is necessary in order for the estimated
4
A multinomial logit model imposes no conditions on the equations to be econometrically identified, and appears to be
rank ordering of buy, ally, and make. Unlike transaction cost theoretically plausible as well as supported by prior empirical
economics, which views these modes of procurement in terms work (e.g., see Poppo and Zenger, 1998). Further, by using two
of increasing degrees of hierarchy, our hypotheses do not suggest instrumental variables for one endogenous variable (procurement
a clear rank-ordering in terms of adaptive capacity. In additional mode) we are able to directly test and verify the assumption
analyses to assess the robustness of our results, we used an that they are exogenous in the performance model (Wooldridge,
ordered probit model instead of a multinomial logit model in 2003).
6
the first stage of our switching regression; the pattern of support Three observations lacked data on performance, and three
for our hypotheses is unaltered. others turned out to be significant influence points.

Copyright  2005 John Wiley & Sons, Ltd. Strat. Mgmt. J., 26: 415–440 (2005)
 Adaptation in Vertical Relationships 431
Table 4. Procurement mode choice (multinomial logit)

Make Ally Buy

1 2 3 4 5

Transaction instability −0.33 −0.30 −0.12 0.03

0.34 0.34 0.17 0.20
Reciprocal interdependence 1.17∗∗ 1.11∗∗ 0.60∗∗ 0.53∗
0.47 0.54 0.27 0.29
Instability × interdependence −0.27 B −0.44∗
0.41 A 0.24
Supplier asset specificity 0.03 0.01 S −0.45∗∗ −0.44∗∗
0.33 0.32 E 0.18 0.19
Buyer asset specificity 0.43∗∗ 0.44∗∗ 0.27∗∗ 0.25∗
0.21 0.21 C 0.13 0.13
Procurement history 2.52∗∗∗ 2.50∗∗∗ A −0.38+ −0.37+
0.83 0.82 T 0.24 0.24
Buyer history −0.30 −0.26 E −0.20 −0.18
0.55 0.57 G 0.23 0.23
Component procurement volume 0.55+ 0.58+ O 0.47∗∗ 0.51∗
0.37 0.39 R 0.22 0.23
Total procurement volume 0.10 −0.16 Y −0.75∗∗∗ −0.82∗∗∗
0.46 0.50 0.24 0.25
Ford −2.50∗ −2.54∗ −0.24 −0.22
1.11 1.16 0.36 0.37
Constant −11.18 −10.99 3.28 3.51∗∗∗
5.21 5.33 1.27 1.33
LR χ 2 48.74∗∗∗ 49.39∗∗∗ 48.74∗∗∗ 49.39∗∗∗
N 219 219 219 219
d.f. 19 20 19 20
Pseudo R 2 0.24 0.25 0.24 0.25

∗
p < 0.10; ∗∗ p < 0.05; ∗∗∗ p < 0.01 in a two tailed test; + p < 0.10 in a one tailed test.
Numbers below coefficients are robust standard errors.

selecting ‘buy’ as opposed to ‘ally,’ but this
puzzling result disappears in the full specification
(column 5). The significant negative interaction
between instability and interdependence suggests
that for non-trivial levels of instability the net
effect of interdependence on the odds of selecting
buy relative to ally is negative. We also note that
reciprocal interdependence and asset specificity
have distinct and independent effects on the
choice of procurement modes, so that our belief
in the distinctiveness of these constructs is
reinforced.
We now turn to the second step in esti-
mating the switching regression model. Using
the predicted probabilities from the multino-
mial logit reported in Table 4, we constructed
the hazard for non-selection into each procure-
ment mode (Hamilton and Nickerson, 2003; Lee,
1982). Table 5 presents the results from the sec-
ond step of the switching regression procedure,
in which we regress the performance of each
Copyright  2005 John Wiley & Sons, Ltd.
procurement relationship on the non-selection haz-
ard, the extent of transaction instability, recipro-
cal interdependence, their interaction and other
control variables except component and total
procurement volumes. The switching regression
model was estimated separately in each subsam-
ple of transactions, i.e., for all transactions clas-
sified as ‘make,’ ‘buy,’ and ‘ally.’ All models
are significant, with R 2 ranging from 16 percent
to 58 percent. Hypotheses 3, 4, and 5 require
comparison of coefficients across these models,
as we are interested in testing the differences
between the marginal effects of transaction insta-
bility, reciprocal interdependence, and their inter-
action across the three modes of procurement.
In addition to robust standard errors (reported
below each coefficient), in order to facilitate inter-
model comparison of coefficients, we calculated
robust standard errors from a combined vari-
ance–covariance matrix using the seemingly unre-
lated estimation algorithm in STATA 8.2. These
Strat. Mgmt. J., 26: 415–440 (2005)
432 R. Gulati, P. R. Lawrence and P. Puranam
Table 5. Performance of procurement modes (switching regression)

Make Buy Ally

a b a b a b

Non-selection hazard 1.29 2.21 (∗ ) 0.34 0.32 0.35 0.32

1.13 (0.84) 1.84 (1.31) 0.48 (0.44) 0.48 (0.44) 0.24 (0.23) 0.24 (0.23)
Transaction instability −0.52∗∗ (∗∗∗ ) −0.58∗∗ (∗∗∗ ) −0.26 −0.25 0.01 −0.07
0.20 (0.15) 0.23 (0.16) 0.17 (0.16) 0.17 (0.16) 0.08 (0.08) 0.09 (0.08)
Reciprocal interdependence 0.54 (+ ) 1.10 (+ ) 0.23 0.23 0.03 0.08
0.50 (0.36) 0.90 (0.64) 0.21 (0.20) 0.23 (0.22) 0.12 (0.12) 0.12 (0.01)
Instability × Interdependence 0.20 −0.20 0.21∗∗ (∗∗ )
0.33 (0.23) 0.26 (0.24) 0.09 (0.08)
Supplier asset specificity 0.26 (∗ ) 0.27 (∗ ) 0.14 0.14 0.36∗∗∗ (∗∗∗ ) 0.36∗∗∗ (∗∗∗ )
0.20 (0.15) 0.22 (0.16) 0.15 (0.14) 0.15 (0.14) 0.10 (0.09) 0.09 (0.09)
Buyer asset specificity 0.44 (∗ ) 0.63 (∗∗ ) 0.01 0.00 −0.05 −0.03
0.30 (0.23) 0.45 (0.32) 0.07 (0.07) 0.07 (0.06) 0.05 (0.05) 0.05 (0.05)
Procurement history 1.26 (∗∗ ) 1.91 (∗∗ ) −0.37 −0.35 0.02 0.01
0.85 (0.63) 1.25 (0.88) 0.27 (0.25) 0.27 (0.25) 0.11 (0.11) 0.11 (0.11)
Buyer history 0.04 −0.32 0.66∗∗∗ (∗∗∗ ) 0.65∗∗∗ (∗∗∗ ) −0.00 0.00
0.38 (0.28) 0.63 (0.44) 0.15 (0.14) 0.14 (0.13) 0.10 (0.10) 0.11 (0.10)
Ford −1.04 −1.51 (∗ ) −0.60∗∗∗ (∗∗∗ ) −0.59∗∗ (∗∗∗ ) 0.26 0.22
0.87 (0.65) 1.25 (0.89) 0.24 (0.22) 0.24 (0.22) 0.20 (0.20) 0.21 (0.20)
Constant −5.30 −8.53 (∗ ) 2.91∗∗∗ (∗∗∗ ) 2.93∗∗∗ (∗∗∗ ) 2.63 2.54∗∗∗ (∗∗∗ )
4.54 (3.37) 6.90 (4.89) 1.04 (0.97) 1.03 (0.95) 0.58 (0.56) 0.59 (0.57)
R2 0.57 0.58 0.28 0.29 0.16 0.18
F 11.28∗∗∗ 7.60∗∗∗ 4.00∗∗∗ 4.00∗∗∗ 2.56∗∗ 2.71∗∗∗
N 20 20 65 65 131 131
d.f. 11 10 56 55 122 121

∗
p < 0.10; ∗∗ p < 0.05; ∗∗∗ p < 0.01 in a two-tailed test; + p < 0.10 in a one-tailed test.
Numbers below coefficients are robust standard errors.
Significance marks and standard errors in parentheses are based on a common robust covariance matrix across models for all three
modes of procurement.

results and the resulting significance levels are
reported in brackets.7
To test Hypothesis 3, we compare the coef-
ficients of transaction instability across the col-
umn ‘a’ models for Make, Ally and Buy, which
only includes the main effects for instability and
interdependence. Hypothesis 3 predicts that the
adaptation pressure arising from transaction insta-
bility has more adverse effects on the performance
of internal procurement than on market procure-
ment or vertical alliances. We find that the coef-
ficient of instability is not different from zero
for Ally and Buy, but is significant and negative
for Make. Therefore, we conclude that Hypothe-
sis 3 is supported in our data. Hypothesis 4 pre-
dicts that the adaptation pressure due to reciprocal
7
Using a common variance–covariance matrix to construct
robust standard errors is useful because it accounts for the effect
of (a) unequal subsample sizes and (b) correlations in the error
terms across the three equations on the standard errors used to
statistically compare coefficients across models.
Copyright  2005 John Wiley & Sons, Ltd.
interdependence between procuring and supplying
units affects market procurement more adversely
than internal procurement or vertical alliances.
Comparing the coefficient of reciprocal interdepen-
dence across Make, Buy, and Ally (column ‘a’),
we find that it has a marginally significant posi-
tive effect on the performance of Make, but has
an effect indistinguishable from zero in Buy and
Ally. We therefore conclude that Hypothesis 4 is
not supported, as external procurement does not do
significantly worse than alliances under conditions
of task interdependence (though it does marginally
worse than internal procurement).
To test Hypothesis 5, we constructed an interac-
tion term between transaction instability and recip-
rocal interdependence. Centered versions of these
variables were used in order to reduce collinearity.
The inclusion of the interaction term does not alter
the basic pattern of results for the main effects. In
addition, we find that the coefficient on the inter-
action term is positive and significant for Ally, but
Strat. Mgmt. J., 26: 415–440 (2005)

is indistinguishable from zero for Make and Buy.
This is consistent with Hypothesis 5, which pre-
dicts that the joint effects of transaction instability
and task interdependence on the performance of
vertical alliances will be less adverse than that on
other modes of procurement. We therefore con-
clude that Hypothesis 5 is supported.
Among the control variables used to test
Hypotheses 3, 4, and 5, we find that supplier asset
specificity has a positive effect on the performance
of internal procurement and vertical alliances, but
not on the performance of market procurement.
This is consistent with standard transaction cost
predictions concerning the hold-up problem. Buyer
asset specificity has a positive effect on the perfor-
mance of internal procurement only. Analogous to
our results in Table 4, these results also point to
the asymmetry between buyer and supplier asset
specificity. We also find that procurement history
has a positive effect on the performance of inter-
nal procurement, while buyer history has a positive
effect on the performance of market procurement.
These results indicate a difference between the per-
formance effects of organizational and individual
histories of prior interaction in internal and mar-
ket procurement. Finally, we note that the non-
selection hazard is not significant in our models.
However, a Hausman specification test indicates
that the coefficients in the models change signifi-
cantly on the inclusion of the non-selection hazard.
This suggests that effects due to self-selection of
procurement modes are operating in our data (and
we have controlled for them), though we may have
been unable to quantify them precisely (see also
Shaver, 1998, for similar findings in the context of
international expansion).
DISCUSSION
In this study, our goal has been to broaden our
understanding of the constraints to adaptation in
exchange relationships beyond incentive conflict
to include constraints arising from limited respon-
siveness to changing exchange conditions and
coordination failures. We have proposed that the
organizational attributes of differentiation and inte-
gration provide a parsimonious and integrated
approach toward analyzing adaptive capacity in
terms of cooperation, coordination and respon-
siveness. Our empirical analysis shows that the
observed levels of differentiation and integration
Copyright  2005 John Wiley & Sons, Ltd.
Adaptation in Vertical Relationships 433
vary systematically with the type of procurement
mode. Thus, different modes of organizing pro-
curement relationships differ not only in the ability
to control hazards of opportunistic renegotiation
but also in their capacity to generate coordinated
responses to adaptive pressures in the task and
transaction environment.
We have also argued that these differences
in adaptive capacity across procurement modes
result in performance differences across modes
of exchange. Our results generally support
this argument as well; the marginal effect of
transaction instability is most adverse on internal
procurement, and the marginal joint effect of
instability and interdependence is least adverse
on vertical alliances. However, we are unable
to detect any differences between alliances and
market procurement in terms of the effects of
task interdependence. Perhaps the differences
in integration between these two modes of
procurement may be small (as also indicated by
the results in Table 3). However, these slight
differences in integration levels may be leveraged
dramatically by the complementarity between
differentiation and integration, as evidenced by
the robust support for Hypothesis 5. Thus, we
conclude that the adaptation perspective can be
useful in understanding performance differences
across modes of procurement in terms of a match
between adaptive capacity and adaptation needs.
The adaptation perspective we develop revives
an extensive tradition of research on adaptation
within organizations (Galbraith, 1977; Nadler and
Tushman, 1997; Nohria and Ghoshal, 1994; Daft,
2001; Donaldson, 2001), which has focused on the
issues of coordination and responsiveness that have
been central to our discussion of adaptive capacity.
In this tradition, scholars emphasized the impor-
tance of limited rationality rather than incentive
conflict as constraints to adaptation, and saw the
essence of organizational adaptation as the gener-
ation of integrated responses to changed circum-
stances (Grant, 1996; March and Simon, 1958;
Simon, 1945). Our study extends this research by
showing that its central ideas are applicable to
adaptation within and between organizations, and
by linking them to recent research on coordina-
tion and adaptation (also see Jacobides and Winter,
2005).
Our study also extends transaction cost anal-
yses of vertical relationships beyond the usual
considerations of incentive conflict. Unlike the
Strat. Mgmt. J., 26: 415–440 (2005)
434 R. Gulati, P. R. Lawrence and P. Puranam
hold-up problem, which emphasizes opportunistic
renegotiation as the primary constraint on adapta-
tion in exchange relationships, we also focus on
the limitations posed by bounded rationality in
responding in a coordinated manner to changed
circumstances (Conner and Prahalad, 1996; Hodg-
son, 2004; Simon, 1991). The novelty of our
approach lies in suggesting that different gover-
nance modes used to organize procurement not
only differ in their consequences for aligning inter-
ests, but also in their ability to align actions
through processes that affect the recognition of
changes in exchange conditions, and the genera-
tion of coordinated responses to such changes.
We have intentionally focused on sources of
adaptation pressures other than volume uncer-
tainty and asset specificity. For instance, transac-
tion instability combines the concepts of volume
and technological uncertainty (Walker and Weber,
1984, 1987). Since we focus on the cognitive lim-
itations of individuals that prevent organizations
from responding to changes in the transaction envi-
ronment, we expect changes arising from demand
and supply conditions (volume uncertainty) and
technology (technological uncertainty) to both cre-
ate constraints on adaptation. Thus, these sources
of uncertainty are seen as equivalent in terms of
their impact on the need for adaptation in vertical
relationships. Whereas an analysis from the per-
spective of hold-up would suggest that the inability
to predict volume requirements in exchange rela-
tionships is likely to bestow an adaptive advantage
on internal procurement, the perspective on adapta-
tion we develop suggests that internal procurement
is disadvantaged in such cases (Hypothesis 3).8
At the same time, our results are broadly consis-
tent with the idea in transactions costs economics
that an important organizational cost of internal
procurement arises from bureaucratic inefficiencies
(Williamson, 1985). Constraints on differentiation
limit adaptation in internal procurement, and may
be seen as an instance of bureaucratic costs arising
from reasons other than the dulling of incentives
within hierarchies.
Similarly, the construct of asset specificity in
discussions of hold-up is related to, but distinct
from, the concept of task interdependence as used
8
It is also worth noting that David and Han (2004: 52) con-
cluded after an extensive review of the empirical literature on
transaction cost economics that ‘there does not seem to be a
clear relationship between uncertainty and either the choice of
governance form or the level of transaction costs.’
Copyright  2005 John Wiley & Sons, Ltd.
in the adaptation perspective presented here. Asset
specificity refers to the need to make investments
specific to a relationship, which once made have
a significantly lower value in other uses. This cre-
ates quasi-rents and the possibility of opportunis-
tic behavior in a bid to appropriate them (Klein
et al., 1978). Interdependence, in contrast, refers
to the existence of complementarities between
tasks; the value of performing one task is a func-
tion of how the other is performed (Milgrom
and Roberts, 1995; Sobrero and Roberts, 2001).
Coordinating interdependent activities to maxi-
mize their combined value involves information-
processing activities such as decision making and
communication to allocate the tasks among indi-
viduals and enable ongoing adaptation and mutual
adjustment between them as the tasks are executed
(Thompson, 1967; Galbraith, 1977; Tushman and
Nadler, 1978; Gulati and Singh, 1998; Sobrero
and Roberts, 2001). Investments in coordination
activities may or may not lead to quasi-rents. For
instance, a number of studies on the effect of
alliance experience on alliance performance find
that learning about managing alliances with one
partner transfers reasonably well to other alliance
partners (Anand and Khanna, 2000; Kale et al.,
2000). Conversely, investments in dedicated assets
may or may not imply ongoing mutual adjustment,
once the investment is made. For instance, firms in
technology partnerships may agree on investing in
a specific technology standard, and such invest-
ments may be highly specific, but, once made,
standards reduce the need for ongoing coordination
(Baldwin and Clark, 2000; Schilling, 2000).9
Like any study, ours also has certain limita-
tions. We depend on a single respondent for data
on each procurement relationship, thus suggest-
ing the possibility of common method bias. Our
approach of contacting the most knowledgeable
informant is consistent with most prior research on
vertical relationships (e.g., Artz and Brush, 2000;
Heide and John, 1990; Kotabe et al., 2003; Poppo
and Zenger, 1998, 2002). As other researchers
have noted (Artz and Brush, 2000), typically only
one individual interacts closely with each sup-
plier on an ongoing basis. To mitigate concerns
about respondent bias, we controlled for the history
of the respondent’s interaction with the supplier
9
David and Han’s review (2004: Table 4) also shows that exist-
ing studies rarely if ever distinguish between the two constructs
of task interdependence and asset specificity.
Strat. Mgmt. J., 26: 415–440 (2005)

and used exploratory factor analysis to verify that
different measures indeed tap into different con-
structs. Our data about exchange performance are
open to criticism for possibly being one sided, as
our measures represent the opinion of the buyers
alone. However, we believe that the buyer’s opin-
ion of performance must correlate reasonably well
with the suppliers, failing which suppliers would
have exited the relationship. The average duration
of the procurement relationship in our sample was
15 years.
Another important caveat is that our measure
of exchange performance is based on perceptual
items measured in reference to the best alternative
supplier for the component. Heterogeneity across
components makes it necessary to measure per-
formance relative to suppliers in that component
class. While a measure of economic performance is
undoubtedly preferable, such data are very difficult
to collect for reasons of confidentiality. Relying
on a perceptual measure comparing the supplier to
all other suppliers for the same component is also
problematic, for we would then be asking respon-
dents to construct an implicit average across all
other suppliers known to them. Our measurement
strategy creates a clear anchor point (the best alter-
native). A problem with such a strategy arises if
unobserved attributes of the component influence
both the covariates of interest as well as the perfor-
mance of the best alternative (and therefore the rel-
ative performance of the focal supplier). However,
our switching regression approach helps alleviate
this problem, as the procedure controls for unob-
served features of components that influence a key
covariate (the choice of procurement mode) and
supplier performance.
Analogous to assumptions about asset speci-
ficity in prior work, the adaptation perspective
we developed makes the simplifying assumption
that reciprocal task interdependence is an exoge-
nous variable. Some scholars have suggested that
interdependence is not completely exogenous, but
firms actively design technical and organizational
interfaces that can lower coordination needs across
organizational and technical subsystems (Galunic
and Eisenhardt, 1996, 2001; Puranam and Singh,
2002; Sanchez and Mahoney, 1996; Schilling,
2000). Ignoring the joint determination of transac-
tion properties and organizational form is a com-
mon failing. Further research on the possible endo-
geneity of task interdependence along the lines of
Copyright  2005 John Wiley & Sons, Ltd.
Adaptation in Vertical Relationships 435
Oxley and Sampson’s analysis of the endogene-
ity of transaction scope, or Novak and Eppinger’s
simultaneous analysis of governance form and
product complexity, would be useful extensions
(Novak and Eppinger, 2001; Oxley and Sampson,
2004).
Despite these limitations, we believe that our
study makes three significant contributions to the
literature on the organization of vertical relation-
ships. First, this study is at once distinct from and
complementary to the voluminous research on firm
boundaries that has primarily built on arguments
about hazards of hold-up and opportunistic renego-
tiation to demonstrate the antecedents and conse-
quences of governance choice. Through this study,
we are able to extend, articulate, and test a perspec-
tive on adaptation in vertical relationships, which
is broader than that in traditional discussions of
hold-up. Adaptation is not only cooperative adjust-
ment; it is also coordinated adjustment. Because
of limited rationality, even agents acting coopera-
tively may fail to successfully adapt in a coordi-
nated manner (Weick and Roberts, 1993). While
others have made these theoretical arguments as
well (e.g., Heath and Staudenmayer, 2000; Kogut
and Zander, 1992, 1996; Zajac and Olsen, 1993),
we have been able to empirically establish that
arguments emphasizing coordination and cooper-
ation are both capable of explaining the organiza-
tion and performance of vertical relationships. Our
results show that asset specificity has predictable
effects on mode choice and performance even after
controlling for factors derived from an adaptation
perspective, and vice versa. Thus, it may be time
to move beyond debates about hold-up vs. other
explanations to begin considering when certain
explanations for economic organization are more
useful than others.
Some recent studies that are primarily motivated
by the hold-up problem have nonetheless begun
to recognize the importance of coordination issues
in exchange relationships. For instance, Oxley and
Sampson (2004) studied the factors that influence
the choice of alliance scope and structure. They
conclude: ‘Our study suggests that these cogni-
tive limitations (as manifested in the importance
of adequate absorptive capacity to support broad
scope alliances involving joint manufacturing) are
an important consideration, in addition to, though
not to the exclusion of—concerns with mitigating
the hazards of potential opportunism.’ Ryall and
Sampson in their analysis of R&D collaboration
Strat. Mgmt. J., 26: 415–440 (2005)
436 R. Gulati, P. R. Lawrence and P. Puranam
contracts note that contracts often embody non-
enforceable clauses that seem to serve only coordi-
native functions. These clauses serve as blueprints
for exchange as a means to ‘plan the collabora-
tion, set partner expectations, and consequently
reduce misunderstandings and costly mis-steps’
(Ryall and Sampson, 2004). Mayer and Argyres
(2004) reach similar conclusions, and draw atten-
tion to the functions of contracts as knowledge
repositories. It is interesting to note that the condi-
tions under which they claim contracts will func-
tion as repositories of knowledge match precisely
the ones in which we emphasize the adaptive
advantages of alliances—the conjunction of insta-
bility and interdependence (Mayer and Argyres,
2004). Our study offers a systematic framework
based on an extensive tradition of research to study
aspects of adaptation in vertical relationships that
are not reducible only to issues of cooperation, but
also require consideration of coordination.
Second, while not the focus of our analysis,
several results on control variables in our study
point to avenues for further research. Our analy-
sis suggests that the distinction between buyer and
supplier asset specificity may be theoretically fruit-
ful. Our results show that buyer asset specificity
makes internal and market procurement preferable
to alliances, while supplier asset specificity makes
market procurement less preferable than internal
procurement or alliances. Whether these differ-
ences in the effects of supplier and buyer asset
specificity merely reflect the institutional context
of the automotive industry, or are meaningful in
other contests, is a useful line of inquiry. We also
find differences between the performance effects
of organizational and individual histories of inter-
action in internal and market procurement. While
procurement history enhances the performance of
internal procurement, buyer history enhanced the
performance of market procurement. Perhaps the
benefits of past interactions are transferable from
individuals to organizations to different degrees in
firm and markets.
Third, this study points to the unique organiza-
tional role occupied by alliances among various
modes of vertical relationships. We predicted and
found support for the argument that alliances rep-
resent balanced levels of differentiation as well as
integration, whereas internal and market procure-
ment emphasize either one or the other. We there-
fore expected (and found) that alliances adapt more
Copyright  2005 John Wiley & Sons, Ltd.
Table 6. Adaptation requirements and optimal procure-
ment mode
Low transaction High transaction
instability Instability
Low task Market Market
interdependence procurement procurement
High task Internal Vertical alliances
interdependence procurement
successfully to the joint effects of transaction insta-
bility and reciprocal interdependence. Our results
indicate that when vertical relationships are char-
acterized by low interdependence and high trans-
action instability, market procurement or alliance
may be the preferred mode of organization. In con-
trast, high levels of task interdependence between
procuring and supplying units combined with fairly
stable transaction conditions make internal pro-
curement optimal. However, when high levels of
instability combine with high levels of interde-
pendence, then vertical relationships may be opti-
mally organized through alliances. These results
also have a puzzling aspect: we are unable to detect
significant differences between alliances and mar-
ket procurement in terms of differentiation, and
only marginally in terms of integration. Therefore,
an obvious question that arises is ‘why are not all
external relationships organized as alliances rather
than arms length arrangements?’ We speculate that
the answer may depend on the costs of estab-
lishing each procurement mode (not considered in
our analysis). If we assume that setting up mar-
ket contracting is the least expensive alternative
(Williamson, 1991a, 1991b), the normative impli-
cations for choosing procurement modes may be
summarized as shown in Table 6.
CONCLUSION
The literature on adaptation in vertical relation-
ships has been dominated by considerations of
hold-up, and increasingly by the debate with its
critics who espouse relational norms as an alterna-
tive to formal ownership and contractual mecha-
nisms to resolve hold-up (e.g., Granovetter, 1985;
Gulati, 1995; Dyer and Singh, 1998; Baker et al.,
2002; Poppo and Zenger, 2002). However, the
view of adaptation espoused by proponents and
Strat. Mgmt. J., 26: 415–440 (2005)

critics is essentially similar—cooperative adjust-
ment, given the hazards of opportunistic behav-
ior. In this study, we refocus attention on the
impediments to adaptation that arise primarily
from bounded rationality, and the organizational
attributes that alleviate them. In doing so, we hope
to re-emphasize a point that sometimes appears
forgotten: that different governance modes are
also different modes of organization, with conse-
quences for adaptation beyond the resolution of
incentive conflict.
ACKNOWLEDGEMENTS
We thank Gautam Ahuja, David Hsu, Dovev Lavie,
Kyle Mayer, Jackson Nickerson, Scott Stern, and
Maxim Sytch for helpful comments.
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