Objectives: Toyota was teetering on the brink of bankruptcy in 1949.  Nissan and Isuzu, the other two major car manufacturers then, were not far behind. The Japanese government did not bail out the car industry. Today, Toyota is the world’s biggest automobile assembler.  This paper examines the role of industrial policy, and the supportive mechanism through which one supplier firm to this Japanese automotive assembler grew to become a highly successful firm at a time when technological change within the Japanese automobile industry was paramount.  The firm was Nippondenso (now Denso).  Denso is one of the world’s largest automotive parts suppliers.

Methods: Case study, historical analysis

Results: Both transaction cost economics (TCE) and the Resource-Based View (RBV) literature have examined Toyota’s inter-firm governance structure and the consensus opinion is that Toyota has a sustainable competitive advantage over auto firms that are more vertically integrated, such as The Big Three.  An industry that wants to protect its proprietary technology tends to integrate that technology for in-house production, lest its technology-based competitive advantage is lost to competitors (e.g. the parts suppliers). The opportunity cost of outsourcing is high.  However, if the issue of opportunism could be resolved, trust-based inter-firm governance structure is an efficient institutional organisation (Adler 2001, p. 224).
This paper submits that a post-war legislation changed the pay-off matrix for the vertical integration versus inter-firm collaboration decision faced by the auto industry in Japan in the 1950s.  Toyota, having narrowly escaped insolvency, and being capital constrained, chose inter-firm collaboration.  Subsequently, Nippondenso became a specialist components supplier, achieving economies of scale and falling production cost.  The common interest objective that was built into the legislation provided strong incentives for both assembler (Toyota) and supplier (Nippondenso) to cooperate for at least fifteen years in a mutually beneficial relationship.  While Toyota preserved its capital, Nippondenso increased its capital expenditure, paying a lower than market interest rate, and it was also able to import cutting edge technology with the government’s foreign exchange allocation.  Outsourcing was a better choice for Toyota for it would not have been able to obtain any of the allocated foreign reserves to pay for imported capital equipment.  The competitive bidding process for special funding and foreign reserve allocation ensured that only the most capable parts suppliers were able to attain fast growth through economies of scale.  Toyota’s initial outsourcing decision developed into a long-term inter-firm governance structure with Nippondenso in a mutually beneficial relationship.  The outcome of this inter-firm cooperation is that both the assembler and the parts supplier have become globally competitive.
This study also shows that with the right incentives and support, it was possible for a supplier to be innovative in exploring two substitute technologies (i.e. electricity versus petroleum), and to provide an environmentally friendlier technology that met consumer demand, given the price of input materials, and the relative price of oil. 

Reference: Adler, P. (2001). Market, Hierarchy, and Trust: The Knowledge Economy and the Future of Capitalism. Organization Science, 12(2), 215-234.