Richard N. Langlois and Paul L. Robertson
The degree of vertical integration in an industry depends on both supply and demand conditions. In this paper, we explore the relationship between supply and demand conditions in shaping the nature of an industry and the scope of activities of specific firms.
The effects of such supply factors as the division of labor, economies of scale, and the presence or absence of external economies have been thoroughly explored over a period of more than 200 years. Demand factors have received less attention. In particular, the tendency of economists to assume product homogeneity has obscured the fact that the structure of an "industry" and the characteristics of the firms it comprises can vary greatly depending on how consumers define its "product." Over time, the nature of what consumers believe is the essence of a given product often changes. Consumers may add certain attributes and drop others, or they may combine the product with another product that had been generally regarded as distinct. Alternatively, a product that consumers had treated as an entity may be divided into a group of subproducts that consumers can arrange into various combinations according to their personal preferences.
We call this kind of network of subproducts a modular system. The nature of an industry and the extent of vertical integration ...