Returns to Specialization, Transaction Costs, and the Dynamics of Industry Evolution

We develop a model of industry evolution to study the process of vertical integration and disintegration (specialization). Absent industry level increasing returns, an industry will be vertically integrated in the long run if and only if transaction costs are greater than the costs of coordinating within a firm. However, convergence to the efficient industry structure may take very long and may not be monotonic: For long periods of time, the industry structure may diverge from its long run equilibrium of vertical integration. When transaction costs depend on the extent of specialization, there can be path dependence and inefficiency even in the very long run. Even when specialization is efficient, the industry may become vertically integrated.