Vertical integration : applying an economic calculus to knowledge

Abstract

This paper applies an economic calculus to knowledge to address one of the most strategically important questions firms face – deciding which activities are more economically organised in a unified firm rather than in two autonomous firms. The conceptual and empirical framework presented here proposes that specialisation leads to differences in cost and technical efficiency of knowledge-based factors of production between adjacent stages in a value chain. These divergent costs and technical efficiencies in turn shape the economics of inter-firm boundary location. A number of dimensions are suggested as being useful for distinguishing between the tacit, codified and encapsulated forms of productive knowledge inputs. Knowledge, so classified, is substituted for labour and capital as factors of production in the traditional microeconomic isocost-isoquant model. This paper applies ‘an economic calculus to knowledge’ [Simon, (1999), p.34] by using “…marginal rates of substitution between one form of knowledge and another” [Simon, (1999), p.24].