Agricultural & Applied Economics Association

Transaction Costs as Determinants of Vertical Coordination in the U.S. Food Industries

Author(s): Stuart D. Frank and Dennis R. Henderson
Reviewed work(s):
Source: American Journal of Agricultural Economics, Vol. 74, No. 4 (Nov., 1992), pp. 941-950
Published by: Oxford University Press on behalf of the Agricultural & Applied Economics Association
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Costs
as
Determinants of
Coordination in
the
U.S.

Transaction

Vertical
Food

Industries

Stuart D. Frank and Dennis R. Henderson

Vertical coordination is a more comprehensive concept than vertical integration,
capturing market, contractual, and ownership coordination. Williamson suggests that
transaction costs motivate the use of nonmarket arrangements to vertically coordinate
production. This paper presents a vertical coordination index incorporating industry
input-output relationships and nonmarket arrangements. In an econometric analysis, the
vertical coordination index is utilized to examine transaction cost effects on food
industry vertical linkages. Empirical results support the hypothesis that transaction costs
are a primary motivation to vertically coordinate via nonmarket arrangements. Results
also suggest the vertical coordination index is more robust than traditional vertical
integration measure.
Key words: contracts, ownership integration, spot markets, transaction costs, vertical
coordination.

Many economic factors affect an industry's ver- the various functions of a vertical value adding
tical organization. Both Coase and Williamson system are broughtinto harmony"(Marion 1976,
(1975, 1979) examine factors affecting the or- p. 180). Vertical coordination encompasses all
ganization of production systems in a market- means of harmonizing vertically interdependent
hierarchy framework. In such a framework, the production and distribution activities, ranging
organizational criterion is minimization of pro- from spot markets through various types of conduction and transactioncosts (Williamson 1979). tracts to complete integration.
Williamson (1979, p. 233) suggests the use of
Several studies (Mighell and Jones; Marion
various administered vertical exchange arrange- 1976; Knoeber) qualitatively examine vertical
ments is motivated by transaction costs, stating coordination antecedents and implications in the
that "if transaction costs are negligible, the or- food sector. These studies casually link transaction costs to vertical coordination. Other reganization of economic activity is irrelevant."
Vertical organization is traditionally consid- searchers empirically examine transactional
ered in the context of vertical integration. How- inefficiencies effects either on vertical integraever, vertical integration is only one mode of tion or long-termcontracts(Joskow, Levy). Such
vertical structure.Vertical coordinationis a more empirical analyses do report transaction cost
comprehensive concept, capturing not only ver- linkages to vertical organization. However, no
tical integrationbut the entire "processby which study uses a single measure of vertical coordination reflecting the full range of options between spot transactions and integration.
Stuart D. Frank is an economist with the Agricultural Cooperative
We introduce here a vertical coordination inService, U.S. Department of Agriculture. Dennis R. Henderson is
a professor, Department of Agricultural Economics, The Ohio State
dex and use it to examine transaction cost efUniversity.
fects on U.S. food manufacturing industries'
This article is based upon research conducted as a part of North
vertical coordination. Our empirical analysis
Central Region research project NC-194, entitled "The Organization and Performanceof World Food Systems: Implications for U.S.
suggests transactional inefficiencies encounPolicies."
tered
by food industries promotes increased utiin
views
this
are
the
authors'
and
do
not
The
expressed
paper
lization of nonmarketverticalarrangements.Most
necessarily reflect the views or policies of the U.S. Department of
Agriculture or Ohio State University.
influential transaction cost factors are those reThe authors extend their appreciation to the anonymous Journal
lated to uncertainty, input supplier concentrareferees for constructive comments on earlier drafts of this paper.
Review coordinated by Steven Buccola.
tion, asset specificity, and internalizationcosts.
Copyright 1992 American Agricultural Economics Association

942

November 1992

Administered Coordination

Amer. J. Agr. Econ.

control as well as degree of interdependency

among firms and industries.
Administered coordination involves the transfer
Traditional industry structure studies employ
of certain rights from one firm to another by variations of the value-added-to-sales ratio in
various coordinatingmechanisms other than spot order to calculate vertical integration. However,
markets. Transferringrights involves a consol- this ratio is influenced by the firm's profitability
idation of control by the contractor or integra- and position in the production process. Hence,
tor.
the ratio is undesirable for use in industry crossAdministered coordination arrangements in- section analysis. Moreover, the ratio does not
clude both contracts and tacit arrangements in capture the firm's partial consolidation of conaddition to vertical integration. Tacit arrange- trol through contracts and other agreements.
ments (for example, providing technical experA second vertical integration measure examtise and advice or increased credit) allow firms ines industry linkages through production funcsome control over vertically interdependenten- tions. Maddigan advances such a measure, capterprisesowned by others (Blois). However, these turing industry input-output interdependencies.
arrangements offer less control than that typi- Through aggregate production functions, intercally conveyed by contracts.
dependencies are expressed by physical inputWilliamson (1979) provides insight into the output coefficients.
structure of contracts within the vertical coorMaddigan's Vertical Industry Connection
dination process. Using Macneil's contract law (VIC) index is a viable starting point for meaclassifications, he advances three contractual suring vertical coordination. Her index exploits
classifications: classical, neoclassical, and re- the interactions of the Leontief input-output
lational. Classical contracts are based on a set model. In the Leontief framework, each x,; in
of legal rules with formal documents and self- input-output matrix X is the optimal value of
liquidating transactions. Neoclassical contracts industry i's output used as an input by indusinvolve longer-term arrangements that do not tryj.
cover all contingencies, but include additional
The input-outputmatrixis manipulatedto form
structures
arbitrathe
initial component of the Vertical Coordina(for
governance
example,
tion). Relational contracts are agreements in tion (VC) index's up- and down-stream interprinciple, which circumscribe the contracting dependentlinkages matrix. Two matrices, A and
parties' relationship, including tacit as well as B (equations (1) and (2)), capture all net production interrelationships for an industry's inexplicit arrangements.
Williamson argues that increases in transac- put-output linkages:
tion complexity, frequency, and uncertainty, acA = I - [xj/(zj - xi1)]+ [y1
companied by idiosyncratic investments, result (1)
in a shift in the coordination structurefrom clasand
sical to neoclassical to bilateral and finally to
unilateral relational contracts. One party typi- (2)
B = [xi,(zi - xii)] - [yj] - I
cally becomes dominant in this progression.
Mighell and Jones discuss several adminis- where I = identity matrix, r x r;
tered arrangements for vertical coordination in
xij = value of ith industry's output used
1 ...., r;
the food sector. They specify three general con- as an input to the jth industry; i, j
tract types: market specification, production
z = total value of industry j's output,
1,..., r;
management, and resource providing. These j
if i = j; 0 if i # j; i,
contract types follow the progression of increasYij= [xii/(z, - xii)]
ing dominance by one party, characteristic also j
... r.
Each element aij of matrix A represents the
of Williamson's classification.
percentage of the value of industryj's net output
contributed by industry i. Each element bijof B
A Measure of Vertical Coordination
represents the percentage of the value of industry i's output supplied to industry j. In short,
A specification that includes both ownership and matrix A represents an industry's up-stream
contractual relationships for vertically interde- connections and matrix B its down-stream conpendent firms or industries provides a more nections. Notationally, inputs are negative as
complete measure of vertical coordination than values used in production and outputs are postraditionalvertical integration measures. Such a itive.
In order to calculate vertical interdependence
specification should include consolidation of

Transaction Costs and Vertical Coordination

Frank and Henderson

for each specific industry, two matrices, CK and

DK, are defined. Matrices CK and DK capture
industry k's primaryand secondary interindustry
connections. The association of industry k with
its interdependentindustriesis determinedby the
flow of net production. These matrices are constructed using the rows and columns of matrices
A and B, specifically the columns of A and rows
of B. Matrices CK and DK are represented by
(3)

cij

as()s(j)

i,j = 1, ..., n (n

and
(4)

i, j

dij = bs(i)s(j)

1,...,

n (n

r)

r)

where s(i) = industries with which industry k is

associated, indexed by i;
cij = percentage of the value of industry
s(j)'s net output supplied by industry s(i);
dij = percentage of the value of industry
net
s(i)'s
output supplied to industry s(j).
In matrix CK, column j (where j = k), industry k has a primary input relationship with industry i; in column j (where j =Ak), industry k
has a secondary input relationship with industry
i. It is the obverse in matrix DK, where, in row
i (i = k), industry k has a primary output relationship with industry j and in row i (i # k),
industry k has a secondary output relationship
with industryj.
To complete the vertical coordination index,
the degree of administrative control that is
consolidated by the contractor/integrator must
be specified. Administration of vertical interdependencies may be accomplished through
ownership and/or a wide variety of contractual
relationships. This implies a progressive consolidation of control between the end points of
no integration (spot markets) and complete integration. Along the continuum, the contractor/
integrator consolidates increasing degrees of
vertical control.
In order to capture the coordination mechanisms of an industry's primary and secondary
interactions, we develop matrices EK and FK.
Each ej represents industry k's measure of consolidated control of up-stream industry i. Similarly, each fj represents industry k's consolidated control of down-stream industry j. To
measure consolidation, each coordinating structure is assigned a value representing percentage
consolidated control. Equation (5) shows the
calculation of matrices E and F:
(5)

e11 andf1

= >
g=l

CLghOgh

943

where g = number of products produced in each

industry, g = 1,...., s;
h = type of coordinating mechanism,
h= 1,..., t;
L = for eii, product g's percentage of industry j's input mixture and,
for fj, product g's percentage of industry
i's output mixture;
O = assigned value of consolidated control;
N = percentage of production coordinated by each transaction type.
With matrices C, D, E, and F, the Vertical Coordination index can be calculated. Equation (6)
is the generalized formulation of the Vertical
Coordination index for industry k:

(6) VCk= 1

(Ci)p(Di)P(Ei)P(Fi)P

where C' = column i of industry k's upstream

connections matrix;
Di = row i of industry k's downstream
connections matrix;
E' = column i of industry k's up-stream
control matrix;
Fj = row i of industry k's down-stream
control matrix;
p = vector dot product;
n = number of industries with which industry k is interdependent.
This specification of Vertical Coordination
(VC) has several desirable properties.'
1. VC increases (decreases) when an input industry becomes relatively more (less) important by accounting for a larger (smaller)
percentage of the total output value of another industry.
2. VC increases(decreases)when relativelymore
(less) of the output of an industry is used as
an input to another industry.
3. VC increases (decreases) as an industry increases (decreases) its number of vertical interactions with other industries.
4. VC increases (decreases) as an industry exercises increased (decreased) up- and/or
down-stream consolidated control.
5. The range of VC is between 0 and 1.
The Vertical Coordination (VC) index's components are influenced, but not skewed, by several factors. Price and quantity changes affect
the values of the input-output matrix and argument L in (5). If xj (input-outputmatrix) or argument L in (5) increases between industries i

gh

h=l

i, j= 1. . ... n(nsr)

' Interested readers

may contact authors for mathematical derivations of the vertical coordination index properties.

944

November 1992

or j, the importanceof the industriesto each other

increases. However, at the same time, all other
linkages of either industry are relatively less important. Thus, VC will increase or decrease depending on the relative magnitudeof the changes
in matrices CK or DK and argument L in (5).
The emphasis of the Vertical Coordination index is on interindustry, not intraindustry, linkages in a vertical system in which industries are
categorized according to a recognized scheme
(for example, four-digit Standard Industrial
Classification, SIC). As firms vertically integrate within their defined classification, value
added by that industryincreases. As value added
increases, interindustryinput-outputvector elements x,; decrease. Therefore, the industry's primary and secondary connections become less
important.
The hypothesis to be tested is that the food
industries' use of various vertical coordination
arrangementsis motivated by transactionalinefficiencies. Although Williamson's transaction
cost paradigm focuses on the firm, our hypothesis is tested using industrydata. Firms use several nonmarketarrangementsin response to various transactionalinefficiencies. The coordination
methods used represent those the firms chose in
order to minimize transactioncosts encountered
when organizing productive activities. Assuming firms within the same industry classification
encounter similar transactional inefficiencies,
industry data should be representative of firm
actions.

Amer. J. Agr. Econ.

vide estimates of contractuse consistent with the

Mighell and Jones classification. Five coordinating methods are used here: 1) spot markets,
2) market specification contracts, 3) production
management contracts, 4) resource providing
contracts, and 5) integration.
Food manufacturers' data on utilization of
the five coordination methods for procuring
agricultural commodities are unavailable. To
approximate food manufacturers'up-stream coordinatingmethods, data on farm sector's downstream contracting are used. The share of total
farm-to-processor product flow of the five coordinating methods is estimated on the basis of
previously reported information (table 1). In table 1, for each coordinating method except spot
markets (which capture the residual value) the
coordination share value SV is
n

(7)

SV

Ai Bi

where A; is farm commodity i's percentage of

total up-stream procurement by each food industry and Bi is the percentage of farm commodity i coordinated by each method. These
shares are used for argument N in (5) to calculate the elements of matrix E.
Argument O of (5) captures consolidation of control associated with each coordinating
method.4 A decreasing marginality function
(concave) is incorporated into the Vertical Coordination measure's calculation." That is, the
percentage of consolidated control increases at
a decreasing rate for each successive coordinaFood Manufacturers' Vertical Coordination
tion method, moving from spot markets (0%) to
integration (100%).
Calculating the Vertical Coordination (VC)
The coordinating method data we utilize
measure requires two major components, inter- poses potential biases in estimating Vertical Coindustry linkages and coordination methods for ordination. Mighell and Jones' contract classithese linkages. First, industry vertical linkages fications do not explicitly incorporatedynamics
are constructed utilizing the 1982 input-output of many vertical arrangementscaptured in Wiltransactions matrix with the four-digit (SIC) liamson's governance scheme. Thus the Mighell
scheme in order to classify firms into indus- and Jones' classifications understate the extent
tries.2 The transactions matrix incorporates the of common or shared control among interdeinput-outputinterdependencies between produc- pendent firms.
tion agriculture (SIC 0111 to 0291) and food
Where there are intermediaries between
manufacturing(SIC 2,011 to 2,099) industries.3 farmers and food processors, the processor's deSecond, it is necessary to have data on the use
of various coordinating methods in agriculture.
4 Several specifications of the degree of consolidated control asWhile there is no systematic reporting of agri- sociated with various coordinating structureswere examined. These
included decreasing marginality, constant marginality, and increascultural contract data, several researchers pro- ing
marginality. In a separate analysis of the three relationships,
2

An input-output transactions matrix was provided by Alward.

3 This specification of vertical coordination is dependent upon
time-specific input-outputcoefficients and is not as robust to changes
in industry definitions or classifications.

the decreasing marginality specification proved superior (Frank, pp.

38-44 and 61-71).
5 The assigned values of consolidated control are: spot market,
0; market specification, 0.5; production management, 0.8; resource
providing, 0.9; and integration, 1.0.

Frank and Henderson

Transaction Costs and Vertical Coordination

945

Table 1. Share of U.S. Food Manufacturing Industries' Farm-OriginatedInputs Coordinated by Various Methods
Contracts

Industry

Spot
marketa

Market
specification

Production
management
(percentage)

Resource
providing

Integration

Meat packing
Sausages and other prepared meats
Poultry dressing
Poultry and egg processing
Creamery butter
Cheese, natural and processed
Condensed and evaporated milk
Ice cream and frozen desserts
Fluid milk
Canned specialties
Canned fruits and vegetables
Dehydrated fruits, vegetables, and soups
Pickles, sauces, and salad dressings
Frozen fruits and vegetables
Frozen specialties
Flour and other mill products
Cereal breakfast foods
Rice milling
Wet corn milling
Dog, cat, and other pet food
Prepared feeds, n.e.c.b
Bread, cake, and related products
Cookies and crackers
Raw & refined cane and beet sugar
Confectionery products
Chocolate and cocoa productsc
Cottonseed oil mills
Soybean oil mills
Vegetable oil mills, n.e.c.
Animal and marine fats and oils
Shortening and cooking oils
Malt beverages
Malt
Wines, brandy, and brandy spirits
Distilled liquor, except brandy
Bottled and canned soft drinksc
Flavoring extracts and syrups, n.e.c.'
Canned and cured seafoods
Fresh or frozen packaged fish
Roasted coffeec
Macaroni and spaghetti
Food preparations, n.e.c.

89.5
89.3
13.0
6.5
17.7
17.7
17.7
19.0
17.7
30.1
35.4
24.9
36.9
24.9
19.3
91.7
81.6
91.5
92.5
93.3
92.4
40.0
100.0
0.0
85.0
100.0
82.3
89.5
89.5
100.0
100.0
93.2
92.5
32.0
92.5
100.0
100.0
100.0
96.0
100.0
11.0
79.0

7.0
7.2
0.0
0.0
81.0
81.0
81.0
70.8
81.0
6.2
10.4
14.0
1.3
14.0
14.0
7.8
13.0
8.0
7.0
6.0
7.1
35.0
0.0
0.0
12.3
0.0
16.7
10.0
10.0
0.0
0.0
6.0
7.0
41.0
7.0
0.0
0.0
0.0
3.0
0.0
0.0
16.0

0.0
0.0
0.0
18.5
0.0
0.0
0.0
3.6
0.0
38.8
30.6
33.4
40.3
33.4
15.7
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
69.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
45.0
0.0

0.0
0.0
73.0
48.2
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
24.1
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0

3.5
3.5
14.0
26.8
1.3
1.3
1.3
6.6
1.3
24.9
23.6
27.7
21.5
27.7
26.9
0.5
5.4
0.5
0.5
0.7
0.5
25.0
0.0
31.0
2.7
0.0
1.0
0.5
0.5
0.0
0.0
0.8
0.5
27.0
0.5
0.0
0.0
0.0
1.0
0.0
44.0
5.0

a Residual values.
b n.e.c. means not elsewhere classified.
c Based upon input-output transactions matrix, industry had no up-stream linkages to agricultural producers (SIC 0111-0291).
Sources: See Frank for complete list.

gree of up-streamcontrol(representedby the farm

sector's down-streamcoordinationdata) is biased
downward by the amount of the processor-intermediary linkage. In addition, if the first handler is also a food processor, integration will be
understatedto the extent that internal transfer of
procured farm commodities exceeds farmerprocessor integration. Many food manufactur-

ing industries also procure a portion of their inputs from other food processing industries.
However, the food manufacturing industries'
up-stream coordinating method data are not
available. Further, the F-matrix in the Vertical
Coordination index (equation 6) cannot be calculated because of the unavailability of food
manufacturers' down-stream coordinating data.

946

November 1992

In the absence of conceptually desirable

data, use of available data understating true
magnitudes should not diminish the underpinnings of our transaction cost and vertical coordination linkage estimates. Arguably, these
linkages would be more pronounced absent such
bias.

Food Manufacturers'Transaction Costs

Variables we use to measure the food manufacturing industries' transactioncosts are presented
below. Transactional inefficiencies are grouped
into four general categories: uncertainty, concentration, idiosyncratic investments, and internalization costs.

Uncertainty
Convention holds that uncertaindemand/supply
causes firms to rely more on nonmarket coordination methods. When transactions are conducted under uncertainty, it can become very
costly or impossible to anticipate all contingencies. In this event, alternative means of coordination that attenuate uncertainty may be more
desirable. To measure uncertainty of food manufacturers' input supply, we use the percentage
change in farmoutputsupply between 1981-1982
(PCFS). If current farm supplies are expected
to fall short of demand, food manufacturersare
motivated to use nonmarket coordination methods to attenuate supply uncertainty. A negative
PCFS coefficient corresponds to an increase in
vertical coordination activity.
To measure unanticipated demand uncertainty, we employ the variance of the residual
of the log of food industry sales regressed on a
time trend (Levy).
k = I ton
(8) LFISk= a + 3 TT +
where LFISkis the log of food industry k's sales
and TT is a time trend.

Concentration
As the number of buyers and sellers in a market
diminishes, small-number bargaining problems
become more prevalent. To reduce potential of
opportunistic behavior when few firms bargain,
firms may utilize nonmarketcoordinating meth-

Amer. J. Agr. Econ.

ods. We employ several variables to proxy the

number of current and future market participants. Williamson (1979, p. 260) states, "as generic demand grows and the number of supply
sources increases, exchange that was once transaction-specificloses this characteristicand greater
reliance on market mediated governance is feasible." The number of potential firms in each
industry is represented by anticipated demand
growth (ADG); this is the time trend coefficient
in (8). The motivation to coordinate vertically
via nonmarketcoordination methods diminishes
as future demand increases.
To capture the food industry's concentration
as a buyer of inputs, we use the food manufacturing industries' four firm concentration ratio
(CR4). We also develop two variables capturing
seller (input supplier) concentration, one each
for the farm output and food manufacturingindustries. Variable FSGC is a farm commodity's
GINI coefficient weighted by that commodity's
net contribution as a supplier to each food industry.6Similarly, variableFUSC is the weighted
four-firm concentration ratio of food manufacturing industriessupplying inputs to anotherfood
manufacturing industry (for example, meat
packing industry supplying inputs to the sausage
and prepared meats industry).
Idiosyncratic Investments
Firms producing specialized or differentiated
products or those with highly intensive technical
production processes may have idiosyncratic investments. A firm at one stage may be able to
appropriatequasi-rents from another firm with
idiosyncratic investments (Klein, Crawford, and
Alchian). In order to attenuateopportunistic behavior, firms increasingly will use nonmarket
vertical coordination. To capture differential
characteristics and asset specificity, we use the
food industry's advertising-to-sales ratio (AS)
and research and development expenditures-tosales ratio (RD).7
6 With the absence of farm production concentration data at the
local level, we use available data at a more aggregate level, which
potentially understates production concentration. At the limit, national GINI's are no larger than local GINI's, and often less. Therefore, the downward bias provides a conservative estimate of what
would be revealed absent such bias. The farm industry GINI coefficient is calculated from Lorenz curves based on the ratio of cumulative percentage of output to cumulative percentage of farms in
each size classification, using Census of Agriculture data.
7 Advertising expenditures were provided by Rogers, and research and development expenditures are reported in Scherer.

Frank and Henderson

Transaction Costs and Vertical Coordination 947

Costs of Administered Vertical Coordination

The same transactional inefficiency factors promoting nonmarket coordination also limit the
extent of internalization. Firms will internalize
transactions up to the point where market costs
of an activity equal the cost of internalization.
Firm characteristicsaffecting internalizationcosts
may include: firm specialization, capital intensity, and flow economies. To proxy these characteristics we use the industry specialization ratio (SPCR), capital-to-salesratio (KS), and a food
production dispersion index (FPDI).
Stigler demonstrates that as a firm specializes
in a particularproduct, it vertically disintegrates
to more fully capture increased scale economies. Hence, as an industry becomes more specialized, it relies less on integration as a coordinationmethod. To maintainproductioncapacity
in a capital intensive environment concomitant
with uncertainty, firms will vertically coordinate. Firms also have an incentive to coordinate
vertically in order to capture production process
flow economies. Physically closer stages of production can more readily capture such economies. We calculate flow economies (FPDI) as
the proximity of enterprises with output-input
linkages. Equation (9) represents industry k's
potential flow economies (FPDI):

(9)

FPDIk =

Wc

Fr

I F - Pi
k = 1 to n

where Fc = percentage of farm commodity c

produced in region i;
Pk = percentage of processed food k
manufactured in region i;
Wc = percentage net contribution of
commodity c to food industry k.
A negative FPDI coefficient implies an increase
in vertical coordination.

Empirical Results
Our analysis examines 42 four-digit SIC food
manufacturing industries using 1982 data. Four
variations of the Vertical Coordinationindex are
specified: (a) VCI: upstream interdependencies
(matrix C, equation (6)), (b) VC2: up-stream
consolidated control associated with various coordinating methods (matrix E, equation (6)), (c)
VC3: upstream interdependencies and upstream
control (matrices C and E, equation (6)), and

(d) VC4: up- and downstream interdependencies

and upstream control (matrices C, D, and E,
equation (6)). Degree of information incorporated into the four measures progressively increases from VC1 to VC4. Examining these four
Vertical Coordinationindex measures reveals the
importance of each component comprising the
most comprehensive measure, VC4.
Each OLS regression estimation was analyzed
for heteroskedasticity and multicollinearity. To
correct for heteroskedasticity one may estimate
the coefficients and t-statistics using White's
heteroskedastic-consistentcovariancematrix. The
Belsley-Kuh-Welsch procedure fails to suggest
presence of multicollinearity in the explanatory
matrix.
Estimated regression coefficients for the vertical coordination variable incorporating only
industry up-stream connections (VC1 in table 2,
column 1) are not revealing. Farm output supply
concentration (FSGC) has a significant positive
relationship with food manufacturer's nonmarket vertical coordination. The remaining concentration variables do not significantly affect
VC1. Flow economies (FPDI) also are a significant motivating factor behind vertical coordination. However, capital intensity (KS) has a
significantly negative relationship with vertical
coordination. The remaining administered cost
variable, along with the uncertainty and idiosyncratic investment variables, do not significantly influence VC1. The VC1 estimation has
a relatively low R2 (0.29) and transaction cost
variables fail to significantly explain the variation in vertical interdependencies (F-statistic =
1.12).
Estimated coefficients in the three vertical coordination regressions incorporating nonmarket
methods (VC2, VC3, and VC4) generally have
expected signs (table 2, columns 2, 3, and 4).
Increased demand (UNANT) and input supply
uncertainty (PCFS) have significantly positive
effects on vertical coordination. Increased input
supplier concentration (FSGC and FUSC) also
appears to increase nonmarket coordination.
However, in the second equation (VC2), food
industry concentration (CR4) has a significantly
negative influence on nonmarket coordination,
while in all three equations anticipated future
concentration (ADG) has no effect. Increased
research and development activities (RD) significantly influence the need to use nonmarket
vertical coordination.
Results are less clear regarding firm and product differentiation (AS). Increased advertising

948

November 1992

Table 2.

Amer. J. Agr. Econ.

Transaction Cost Effects On Vertical Coordination

Dependent variables

Explanatory
variables

VCl
0.28

constant

(0.70)
0.38
(0.90)
0.05

PCFS
UNANT

(0.06)
0.0003

CR4

(0.15)
ADG
FSGC
FUSC
RD

-0.20
(0.15)
0.32
(4.03)
-0.0004
(0.34)
1.87

(0.32)
AS
KS
SPCR
FPDI
R2
F-statistic
Degrees of freedom

-1.78
(1.51)
-0.46
(2.63)
-0.0006
(0.16)
-0.04
(1.63)
0.29
1.12
30

VC2

VC3

VC4

1.82

1.45

1.18

(3.83)

(3.78)

(3.22)

-2.44
(4.62)
-0.50

(0.57)
-0.005

(2.26)
0.33
(0.25)
0.84
(6.56)
0.006
(4.39)
24.09

(3.55)
3.31
(2.51)
0.17
(0.76)
-0.02
(4.91)
0.02
(1.06)
0.71
6.72
30

-1.37
(2.91)
0.37

(0.51)
-0.003

(1.25)
-0.35
(0.28)
0.99
(10.85)
0.005
(4.45)
16.39

(3.23)
0.05
(0.04)
-0.19
(0.94)
-0.02
(4.27)
-0.008
(0.34)
0.78
9.46
30

-1.00
(2.44)
0.83

(1.31)
-0.0008

(0.37)
-0.55
(0.46)
1.01
(12.06)
0.004
(3.89)
16.96

(3.80)
-2.20
(2.08)
-0.06
(0.33)
-0.01
(3.80)
-0.03
(1.31)
0.77
9.14
30

Note: Values in parentheses are t-statistics.

has a significantly positive effect in the second

equation (VC2) and a negative effect in the third
(VC3). Results also indicate firms increasingly
use nonmarket coordination to capture flow
economies (FPDI) and are less integrated when
more specialized (SPCR). However, capital intensity (KS) appears not to affect vertical coordination. The three estimated relations explain
at least 71% of total variation in vertical coordination. Each equation provides a strong statistical relationshipbetween transactioncosts and
vertical coordination (F-statistics significant at
the 1% level).
The vertical coordination measure incorporating only up-stream interdependencies (VC1)
is statistically not revealing, while the measure
of up-streamcoordinatingmethods (VC2) is quite
significant. However, the two measures that
combine coordinating methods and input-output
interdependencies (VC3 and VC4) have the largest R2's and F-statistics.
We regressed conventional vertical structure
measures on the same transactioncost variables
and compared results with the most complete
vertical coordination measure (VC4). Maddi-

gan's Vertical Industry Connections (VIC) index captures both up- and downstream interdependencies (table 3, column 1). Only two
variables, farm sector concentration(FSGC) and
flow economies (FPDI), have expected signs and
are statistically significant. Estimated coefficients of idiosyncratic investments (AS) and
capital intensity (KS) have negative relationships with VIC and are also statistically significant. The remaining estimated coefficients are
not statisticallydifferentfrom zero. Overall, VIC
is not revealing. Its estimated equation has low
R2 (0.34) and the F-statistic (1.38) is not significant. Vertical coordination(VC4), which adds
coordinating methods to VIC, performed considerably better. Coordinating methods appear
to be important when empirically examining
vertical coordination.
The second variable examined is the traditional vertical integration (VI) measure, defined
as the value-added-to-sales ratio (table 3, column 2). Input uncertainty (PCFS), concentration (CR4 and FUSC), and idiosyncratic investments (RD and AS) regression coefficients
are statistically significant with expected signs.

Transaction Costs and Vertical Coordination 949

Frank and Henderson

Table 3. Comparisonsof Transaction Cost Effects On Vertical Coordinationand Vertical

Integration
Dependent variables
Explanatory
variables
constant

VIC

VI

0.06

0.12

(0.15)
PCFS
UNANT
CR4

0.49
(0.84)
0.46
(0.50)
0.002

(0.53)
-0.47
(1.47)
-1.22
(2.43)
0.001

(1.30)
ADG
FSGC

-0.54
(0.41)
0.35

(1.31)
0.42
(0.74)
-0.06

(3.63)
FUSC
RD
AS

KS
SPCR
FPDI
R2

F-statistic
Degrees of freedom

VC4
1.18

(3.22)
-1.00
(2.44)
0.83
(1.31)
-0.0008

(0.37)
-0.55
(0.46)
1.01

(0.80)

(12.06)

-0.001
(1.07)
2.31
(0.41)
-4.09
(3.64)

0.003
(4.99)
6.46
(1.84)
2.47
(2.41)

0.09

0.004
(3.89)
16.96
(3.80)
-2.20
(2.08)

-0.06

(1.76)
0.002
(0.42)
-0.05
(1.72)
0.34
1.38
30

(0.80)
0.0001
(0.03)
0.008
(0.63)
0.65
5.05
30

(0.33)
-0.01
(3.80)
-0.03
(1.31)
0.77
9.14
30

-0.30

Note: Valuesin parenthesesare t-statistics.

Only the demand uncertainty (UNANT) coefficient has a significant and unexpected sign. Statistically, remaining coefficients do not affect
verticalcoordination.The verticalintegration(VI)
equation performs well relative to VIC, with an
R of 0.65 and F-statistic significant at the 1%
level.
Comparing vertical integration (VI) and vertical coordination (VC4) equations is revealing
(table 3, columns 2 and 3). The vertical integration (VI) equation has only five statistically
significant transaction cost variables with the
hypothesized signs, while the most complete
vertical coordination measure (VC4) has seven.
Vertical coordination measure VC4 is more robust with higher R2 and F-statistics.
This result supports a vertical organization
measure focusing on interindustrylinkages and
nonmarket arrangementsas opposed to a valueadded integration measure employed in crosssection analysis. For instance, vertical coordination (VC4) is influenced by input supplier
concentration (FSGC and FUSC), uncertainty
(PCFS and UNANT), and factors affecting scale

economies (SPCR and FPDI), whereas vertical

integration is affected by input uncertainty
(PCFS), concentration (CR4 and FUSC), and
idiosyncratic investments (RD and AS). Furthermore, two statistically significant variables
in the vertical integration(VI) equation (CR4 and
AS) are stronglyrelatedto profitabilityand valueadded, which are inherentin the traditionalvalueadded-to-sales ratio. Such a result continues to
bias industry cross-section vertical integration
studies.

Conclusions
We have developed a vertical coordination measure that incorporatesproduct flow linkages and
coordinating methods utilized between vertically interdependentindustries. Empirical analysis supportsthe hypothesis that transactioncosts
are a primary motivation for vertically coordinating via nonmarket arrangements. The most
influential transaction cost factors are related to
uncertainty, input supplier concentration, asset
specificity, and scale economies.

950

November 1992

Comparingvertical coordinationmeasures that

only captureproductflow interdependencieswith
other specifications that incorporate coordinating methods as well, reveals the importance of
nonmarket exchange mechanisms in reducing
transactional inefficiencies. Previous industrial
organization studies have not examined empirically the combined role of nonmarketexchange
mechanisms and vertical integration. Our results
demonstratethat an industrial organization variable incorporating coordinating methods and
technical input-outputinterdependenciesbridges
the market versus ownership coordination dichotomy. Our vertical coordination measure is
acceptable for use in cross-section analysis because it focuses on interindustrycoordination.
Transaction cost economics provide considerable insight about the determinantsof vertical
coordination. Great strides are being made in
transaction cost economics methodologies, although obstacles remain to be overcome. There
are difficulties in observing and quantifying
transactionalinefficiencies. In order to improve
the vertical coordination measure's accuracy, a
generally accepted and comprehensive list is
needed of definable coordinating methods in the
farm and food sectors. With such a list, detailed
data could be collected on the use of each coordinating arrangement. Ultimately, we are interested in knowing how vertical coordination
hampers or enhances competitiveness, profitability, and economic welfare.
[Received December 1990; final revision
received March 1992.]

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