In 1986, the Taiwanese government freed the raw material market of the petrochemical industry, previously monopolized by China Petroleum Company. Following this, a growing number of entrepreneurs entered the petrochemical industry investing in the upstream supply of raw materials. What led to this strong tendency toward backward integration in the petrochemical industry? Were the high transaction costs an important factor contributing to this backward integration? What are the causes of the high transaction costs?
To answer the above questions, a transaction cost model of the degree of vertical integration is tested. The model is verified by the Tobit analysis with 25 observations to demonstrate that backward integration is the result of high transaction costs. The empirical results indicate that transaction cost theory helps explain the behavior of backward integration in the petrochemical industry, with the small number of exchanges, asset specificity, and scale of production as more important factors.
From case studies of backward integration in the Taiwanese petrochemical industry, it is understood that in order to make the market mechanism work, reducing transaction costs is essential. Since human and environment factors are uncontrollable, performance of the market mechanism can only be enhanced by improving the transaction system. However, government interference and inappropriate control not only obstructs the operation of the market mechanism but also increases the transaction costs. Therefore eliminating all unnecessary interference (for example, import/export controls, factory setup restrictions, price controls and so on), promoting the exchange of market information, and establishing a competitive market are areas that the government needs to explore.