A transaction cost approach to Vertical Integration

* Vertical integration should be considered when the transaction costs of using the marketplace increases * Such transaction costs include: costs of governing relationships between suppliers and buyers, such as search, selection, bargaining, monitoring, and enforcement * According to the basic transaction cost economics framework, the decision to use the market or vertical integration is determined by two major variables: asset specificity and frequency of transaction and ultimately by the need to hedge against uncertainty
Asset specificity: Obtaining the quality grapes needed to make its premium wines is a transaction that should be considered asset specific because wineries such as Mondavi targeting the premium segment want to be able to differentiate the grapes its wine is made of from competitors. Hence the vineyards it uses need to be tailored to produce grapes of a certain quality. In this sense, Mondavi is exposed to serious risks of loss and damage if the quality of the grapes is not as expected. Consequently, it needs to seek maximum control of the process to minimize the risk of producing a less adequate wine and eroding brand equity. This involves high transaction costs to make sure suppliers are taking the necessary steps to ensure the quality of the grapes. This is likely the reason why Mondavi has expressed his objective to increase internal sourcing from 7% to 25%. By investing in its own vineyard, this will eliminate the cost of monitoring the quality of grapes, the cost of having to search for suppliers that will produce the level of quality required by Mondavi. By integrating upstream, this will simultaneously decrease transaction costs and eliminates the uncertainty having to depend on suppliers, and ultimately ensures that grapes are of good enough quality to protect their brand equity.
Consequently, such wineries will seek maximum control of the process to minimize the chance of losing reputation.
Consequently, such wineries will seek maximum control of the process to minimize the chance of losing reputation.
Consequently, such wineries will seek maximum control of the process to minimize the chance of losing reputation.
Frequency: Frequent transactions of the grape procuring process raise costs for the simple reason that haggling and negotiating occur more often due to the inconsistency of grape quality and allow for frequent exploitation. By vertically integrating, such transaction costs can be eliminated and will ensuring supply of enough grapes at acceptable prices. Again, by vertically integrating, this avoids having to depend on suppliers and avoid uncertainty, especially for an input of the utmost importance when the final produce is wine. * This can be summarized in the Transaction-Asset Matrix Transaction Frequency | Frequently | Standardized transitions (e.g. groceries) | Vertical Integration | | Infrequently | Detailed standardized contracts (e.g. rending office space) | Detailed unique contract (e.g. construction project) | | | Low | High | | | Asset Specificity |

Conclusion
Whether to integrate or not is ultimately about risk management and hedging against uncertainty. By increasing its backward integration and investing in its own vineyards Mondavi will grow more of its own grapes. This allows it oversee soil conditions; spacing of plants and observe general growing conditions that allows it to have full-control over the grapes. Such increased attention to vineyards enables Mondavi to produce a higher quality final product.
Consequently, such wineries will seek maximum control of the process to minimize the chance of losing reputation.
Consequently, such wineries will seek maximum control of the process to minimize the chance of losing reputation.