Vertical Integration, Appropriable Rents, and the Competitive Contracting Process BA549A Session 2: Transaction Cost Economics - Theory Benjamin Klein Robert G. Crawford Armen A. Alchian Journal of Law and Economics (1978) by Eunkwang Seo

Two Types of Transaction Costs Ex-ante Transaction Costs AGENDA Main Question Q. When is vertical integration chosen over market contracts for economic transactions? Two Types of Transaction Costs Ex-ante Transaction Costs : Searching and information costs, negotiation, and bargaining costs… Ex-post Transaction Costs : Monitoring costs, enforcement costs, dispute-settling costs …. The primary purpose of this article is to show how the possibility of post-contractual opportunistic behavior can lead to the vertical integration of economic transactions.

ASSET SPECIFICTY AND VERTICAL INTEGRATION Monopoly Rents vs. Quasi Rents The economic quasi-rent value of the asset is defined as the excess of its value over its value of its next best use to another user. The presence of appropriable quasi rents generated by asset specificity is the primary determinant to vertical integration. That is, vertical integration is a means of economizing on the costs of avoiding risks of appropriation of quasi rents in specialized assets by opportunistic individuals. Monopoly Rents Quasi Rents Abnormal returns caused by limited market entry Abnormal returns caused by specialized assets

ASSET SPECIFICTY AND VERTICAL INTEGRATION Causal Mechanism STAGE 1. Press Owner = $1,000 salvage value & $1,500 operating costs Publisher B = Pays $5,500 for the printing service Current Profits = $5,500-$1,500-$1,000=$3,000 STAGE 2. Publisher C =Offers $3,500 for the printing service Quasi Rents = $5,500 (B’s offer) - $3,500 (C’s offer)=$2,000 Appropriation Risks = The quasi rents ($2,000) can be appropriated by Publisher B undercutting the price to $3,501. Specialized Assets Assumption(?) Quasi Rents Presence of Opportunism Appropriation Risk Increased Transaction Costs

ASSET SPECIFICTY AND VERTICAL INTEGRATION Contractual Solutions Explicit Long-term Contracts An explicitly stated contractual guarantee legally protected by government or some other outside institution. Implicit Long-term Contracts An implicit contractual guarantee enforced by the market mechanism of withdrawing future business if opportunistic behavior occurs (agreements of reciprocity). However, under uncertainty, it is costly to explicitly specify all contingencies. Also, it is hard to ensure that the threat of reciprocity (premium payments) is sufficiently large over the benefits of opportunistic behavior. The cost of using market transactions increases proportionally to asset specificity.

ASSET SPECIFICTY AND VERTICAL INTEGRATION Core Assumption It is reasonable (?) to assume that any internal coordination or other ownership costs are NOT systemically related to the extent of the appropriable specialized quasi rent of owned assets. Prediction If an asset has a substantial portion of quasi rent which is strongly dependent upon some other particular asset, both assets will tend to be owned by one party (vertical integration).

EXAMPLES GM and Fisher Body Investment in Specialized Assets In 1919, GM signed a ten-year contract with Fisher Body for the supply of closed metal bodies. Contractual Devices To encourage the firm-specific investment, GM provided an exclusive dealing clause to Fisher Body on a cost plus 17.6% basis. Unexpected Changes in Market Early1920s, demand for closed metal bodies drastically increased, and thus the cost plus 17.6% becomes too high to GM. Opportunistic Behavior of Fisher Body Fisher Body refused to adjust the price and to move closer to GM. Vertical Integration In 1926, GM acquired the remaining stock in Fisher Body.

Specific Human Capital EXAMPLES Petroleum Industry Market Power of Pipeline Owner Since the pipeline is a specialized asset, the owner can purchase crude oil at a a least cost and sell it to refineries at a highest price. Thus, crude oil producers and refiners tend to have a joint ownership of the pipeline corresponding to the relative share of oil used. Specific Human Capital Employee Union Unions are more likely to exist when the opportunistic cheating problem is greater, namely, when there is more specific human capital present.

CONCLUSION AND DISCUSSION Hybrid Control Mechanism The distinction between transactions made within a firm and transactions made in marketplace may often be too simplistic (Hennart, 1993). Many long-term contractual relationships (e.g., franchising) blur the line between the market and the firm. Thus, the pertinent economic question will be “What kinds of contracts are used for what kinds of activities, and why?” Discussion Questions: Relationship between asset specificity and internal coordination costs? Given asset specificity, which party is more likely to be opportunistic? An asset owner, or a user?