Firms vertically integrate to avoid dependence on external providers/clients. At the same time, vertical integration offers the possibility to exploit existing capabilities among similar stages and pursue flexibility. This article attempts to analyze how firm size affects these vertical integration drivers, proposing a model and testing it in 155 firms. For all firms, the decision to vertically integrate is a trade-off firms exchange greater flexibility for the security of lower opportunism and better use of their own capabilities. Results indicate that the impact of vertical integration is more noticeable in small firms than in large ones. As firms grow in size, they are less likely to worry about staying flexible and instead focus more on leveraging capabilities along the value chain.
A firm vertically integrates when it links products in adjacent stages of production within a "value-added chain" and internalizes exchanges that would otherwise take place in open markets (D'Aveni and Ilinitch 1992). According to past research, firms decide to vertically integrate when market conditions make market exchanges costly, especially when the firms are dependent on external providers or clients that are able to behave opportunistically (Williamson 1985). More recently, several studies have complemented this market point of view by analyzing the role that internal characteristics of firms play in establishing firms' vertical boundaries (Hoetker 2005; Leiblein and Miller 2003). A firm, as a pool of knowledge, abilities, and experiences, will undertake internally those stages in which it can apply existing capabilities.
Although this reasoning can be applied to firms independently of their size, it should be remembered that small enterprises are not smaller versions of larger companies (Shuman and Seeger 1986). Small firms differ from large ones in a variety of ways, including greater problems in building a reputation (Fombrun and Shanley 1990), informal communication patterns and lower levels of specialization (Hutchinson 1999), and a smaller variety of markets and products (Birley and Westhead 1990). These differences increase small firms' dependence on external providers or clients and consequently affect vertical integration decisions. Also, small firms are more limited in terms of financial, human, and physical resources availability (Morrison, Breen, and Ali 2003), which encourages them to vertically integrate and exploit their existing capabilities along the value chain rather than invest in developing new capabilities. Moreover, vertical integration offers small firms greater flexibility than large companies, an advantage when faced with frequent changes on demand (Park and Krishman 2001).
The objective of this research is to analyze vertical boundary differences among different-sized firms, taking into account such topics as their dependence on external providers and clients, their internal pool of capabilities, and their response to uncertainty. A variety of questions must be addressed. What role does firm size play in establishing vertical boundaries? How does the motivation to vertically integrate change as firms increase in size? Do small firms prefer to stay flexible and specialized, thus avoiding having to negotiate with external providers and clients, in order to better exploit their capabilities?
In trying to answer these questions, this article contributes to the development of current research on both vertical boundaries and small firms. The model proposed analyzes the moderating effect that firm size has on factors traditionally identified in vertical integration literature. The analysis begins with a theoretical examination of the particular characteristics of small and large firms in order to understand how size changes vertical integration drivers. Although several papers have taken into account firm size to explain vertical integration (Poppo and Zenger 1998; Levy 1985), few papers analyze how firm size affects the explicative power of drivers of vertical boundaries. …