The effect of information technology on average firm size and the degree of vertical integration in the manufacturing sector

Ronald Coase and Oliver Williamson, in their transaction-cost framework, posit that economic transactions can occur within either hierarchies (i.e. firms) or markets (i.e. market-oriented transactions). They hypothesize that firm size and degree of vertical integration depend on the relative costs of using hierarchies and markets. If in a specific industry the costs associated with market use are high relative to hierarchy use then, ceteris paribus, that industry would be characterized by large and highly vertically integrated firms. If the costs associated with market use were low relative to hierarchy use then the opposite would be the case. Up to the late 1960s average firm size had been increasing in the United States manufacturing sector but afterwards started to decline. Simultaneous with this decline, there was a tremendous increase in investment in information technology capital, from $18.5 billion in 1973 to \$253.7 billion in 1989. This vast expansion in information technology capital has, it is posited, reduced communication and data handling costs, the primary components of search costs. Since market use is more search cost intensive than hierarchy use then the cost of market utilization will have fallen vis-a-vis hierarchy utilization. Hence it is expected that the increase in information technology capital has lead to smaller firm size and less vertical integration. This hypothesis was tested with a series of pooled cross-sectional regression models that made use of data for the U.S. manufacturing sector as well as data for a cross-section of nations for the manufacturing sector as a whole and, separately, for the transportation equipment and electrical machinery industries. The international data was used in order to determine if the posited relationship held internationally as well as for the U.S. The empirical evidence obtained from these models strongly supports the posited hypothesis that information technology capital has caused a decline in firm size and the degree of vertical integration. The proxies used for information technology capital, in nearly all the models used, had the predicted sign and the majority of these signs proved significant at the 10% level of significance.