Here is the conclusion from Kirk Monteverde and David J. Teece’s 1982 paper, Supplier Switching Costs and Vertical Integration in the Automobile Industry:
Transactions cost considerations surrounding the development and deepening of hu- man skills appear to have important ramifications for vertical integration in the auto- mobile industry, thereby supporting the transactions cost paradigm advanced by Williamson. GM and Ford are more likely to bring component design and manufacturing in-house if relying on suppliers for preproduction development service will provide suppliers with an exploitable first-mover advantage. We posit that this is a result of the high switching costs entailed if the supplier acquires transaction specific know-how at the assembler’s expense. Since know-how cannot simply be transferred from supplier to supplier like a book of blueprints (Winter, 1980), backward integration is the more prudent course of action. General Motors and Ford also have a preference for backward vertical integration when the components are firm-specific and their design must be highly coordinated with other parts of the automobile system. [emphasis added]
Hence, the vertical structure of GM and Ford appears to be based at least in part on efficiency considerations. Specifically, the structure appears to be designed to take advantage of the coordinating properties of hierarchies as well as the ability of internal organization to reduce the exposure of the automakers to opportunism from suppliers — a hazard which is apparently absent in the less integrated Japanese industry where “the relationship between the major auto firm and its satellite suppliers is one of total cooperation” (Ouchi, 1981, p. 19).
Defense policy-makers seem to want the Japanese outcomes — total and complete cooperation of suppliers — rather than considering the merits of vertical integration. Yet the Japanese automakers still build things, and thus have less information asymmetry when monitoring the cooperation.
DoD, on the other hand, has in many cases neutered its own design and production capabilities (aside from a few S&T labs and the Navy warfighting centers). In times past, DoD was responsible for developing a suite of components, and even built artillery at arsenals including Watertown and built ships such as at Brooklyn shipyard.
When the Army thought about competing an organic design for the OMFV program, the backlash was so thorough that the Army withdrew.
Whether or not you believe that government employees can have the incentive to work creatively and efficiently, vertical integration is the other side of the coin to market transactions. When uncertainty and transaction costs are too high, firms internalize costs. Otherwise, why would there be these “islands of consciousness” or “islands of socialist planning” within a sea of market activity?
SpaceX is a classic case where high supplier costs caused vertical integration, and far superior outcomes at a lower price. Here is a slice from Matthew Liskowycz’s AFIT thesis:
SpaceX implemented two innovative techniques that allowed them to overcome the entry barriers in the SLV industry. First, they implemented vertical integration to reduce cost and development time. This practice was previously unheard of in an industry that had previously prided itself on spreading development and operations among many other companies. Secondly, SpaceX is developing reusable launch vehicles to reduce the cost of entry to space.
… SpaceX’s biggest reason for being able to cut costs so rapidly was the implementation of vertical integration. Therefore, the U.S. Air Force should encourage vertical integration by providing subsidies to companies that implement this strategy to consolidate the manufacturing and assembly process.
One important aspect of this vertical integration is that it takes substantial capital investment. Defense companies are not incentivized to make such capital investments unless DoD signs off on it because the company cannot be sure whether they will win a program — or that a program will even be funded. So defense companies maximize labor input rather than capital input, with the added benefit of more voters to influence politicians.
Certainly vertical integration gets rid of transaction cost problems and layering of profit-on-profit. But if DoD had an incentive for best product at lowest price, then companies should be seeking efficiency on their own. Whenever DoD needs to tell suppliers how to do business, you’re in a world of trouble.
BTW — another aspect of DoD which prevents the Japanese outcomes of “total cooperation” is the rise of commercial item contracting in the 1990s, which purposefully removes many reporting and regulatory requirements that reduce information asymmetry. A commercial item is not just one sold on commercial markets, but also defense unique items that derive from commercial technologies.
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