Revisiting Vertical Scope: Capabilities, Integration and Profitability in the Mortgage Banking Industry

This paper reconsiders the drivers and implications of vertical scope, in particular by fleshing out currently loose theorizing about capability-driven integration. As the transaction-cost based view cannot fully explain vertical channel choices in our large-scale US Mortgage Banking Database (especially "mixed" production / procurement structures), we consider the need for new theory, informed by qualitative and quantitative evidence. Using an analytical model as a tool, we answer the following questions: How do differential firm capabilities and their distribution affect the choice of vertical scope? What is the role of limits to replication? How do transaction costs, widely construed, catalyze and combine with capability distribution in shaping vertical scope in the firm and industry level of analysis? In particular, how is mean profitability and variation in profitability across firms in an industry related to capability distribution, replication and transaction costs? How do limits to growth affect vertical scope and profitability? The model builds on programming and activity analysis, and uses tools from computational general equilibrium theory to provide new theoretical insights on drivers of scope, as well as its profitability implications. The model's structure and mechanics are motivated from interviews with executives; references to the mortgage banking industry provide empirical illustrations. The paper concludes by reviewing some applications, such as how information technology affects value chain structure and profitability distribution, and what accounts for the growing concentration in servicing, despite declining economies of scale.