The Choice of Organizational Form Joshua Downs 8/31/2015 Anand RV 9/05/2017 The Choice of Organizational Form Vertical financial ownership versus other methods of vertical integration Mahoney, 1992. SMJ

Main Points Why ownership may be unnecessary? Presents a generalized theory for predicting organizational form Integrates and extends previous work done under both the strategy and industrial organization paradigms Key reasons for vertical integration Strategic considerations, input and output price related, uncertainty in costs or prices Why ownership may be unnecessary? Other organizational forms may provide similar efficiencies Advantages and disadvantages of financial ownership Predicting the organizational form Integrating agency and TCE Motives cannot predict form; form cannot predict motives ¡

Why Vertically Integrate? Strategic motives (role of regulatory environment?) Increase entry and exit barriers Price squeezing Output and/or input price advantages VI can help evade monopoly prices charged upstream Addresses risk of arbitrage between sets of downstream firms with heterogeneous price sensitivities when price discrimination is practiced Uncertainty Asymmetric information between upstream and downstream stage participants, risk of supply failure or overproduction respectively Integration improves forecasting for pricing and capital investment Inconsistent findings on whether vertical integration reduces demand and technological uncertainty Discrepancy between VI and risk/uncertainty reduction claims (Williamson and Harrigan) Reconciled by discussion of dynamic or static levels of asset specificity Measurement and quality uncertainty (and other types of uncertainty) Key input quality and point of sale service Disagreement regarding technological uncertainty and likelihood of VI (key: asset specificity)

Are contracts equivalent to ownership? Contracting can address concerns that financial ownership also does What are the advantages of doing so? Equivalency proposition of Coase theorem “The initial assignment of property rights does not matter” Extend arguments for ownership to vertical integration and apply to long-term contracts

What Determines Organizational Form? Transaction costs concerning attributes of the transaction Ex ante costs: Search and information, Drafting, bargaining, and decision, Agreement safeguarding Ex post costs: Monitoring and Enforcement, Adaptation and haggling, Bonding, Maladaptation Agency costs concerning incentives and measurement problems of the individual Monitoring by principal, bonding expenditures by agent, loss of residuals 2 Branches Mathematical Principal Agent Models Unboundedly Rational, Firm as nexus of contracts, Alignment of ex ante incentives sufficient to achieve vertical financial ownership outcomes through contracting Positive Agency Theory Emphasizes information asymmetry issues, reward based on output or behavior Nonseparability of effort to output Low task programmability reduces effectiveness of monitoring Measurement costs and transaction costs should be considered simultaneously for the purpose of predicting organizational form Emphasis on Measurement problems fills Transaction Costs Gap (571)

Advantages of financial ownership Profit Costs related to preemptive claims on profit by separate firms eliminated Coordination and Control Authority derived inducements to reduce opportunistic behavior Resolution of conflict more efficiently achieved internally than through 3rd party (litigation) Audit and Resource Allocation Internal divisions can be audited, superior information on which to base allocations so as to eliminate opportunistic behavior Motivation Inculcation of solidarity (organizational identity) converges interests to reduce behavioral uncertainty Communication: Internally coded communication more efficient than external communication Even frequent interactions feature opportunism concerns

Disadvantages of financial ownership Bureaucratic Costs Difficult to anticipate, synergies overestimated Additional tasks may require additional skills Increasing superior/subordinate spans obviates communication advantages Lack of market incentives leads to increased slack, norms of reciprocity form Strategic Costs Reduced access to knowledge of from severing ties to outside partners Specialized assets (Indivisible?) leading to excess capacity Reduced flexibility, increased exit barriers, psychological commitments and divestment related administrative difficulties Flexibility/Stability tradeoffs Production Costs Internal Inputs must be sufficiently utilized to achieve sufficient scale compared to market sourced inputs of competitors Capital drain concerns for small firms (Williamson, 1975) Capacity imbalances (among stages of production)

What Should the Organizational Form Decision be Based Upon? Framework for Predicting Organizational Form Transactions dimensionalized according to frequency, uncertainty, and asset specificity Uncertainty (Demand and technological) and asset specificity (Human, Physical, Site) Frequency only influences structure choice in intermediate asset specificity, not considered Agency perspective emphasizes information asymmetry/measurment issues Nonseparability (measurement of output) Task Programmability (measurement of input; effort) Integration of theories Task programmability, nonseparability, demand uncertainty, technological uncertainty, and asset specificity are five determinants of organizational form Demand and technological uncertainty are theoretically indeterminate, thus model focuses on interactions of remaining 3 dichotomous variables as determinants of organizational form

Discussion questions How much does industry matter in accurately predicting organizational form? When search and information costs and monitoring and enforcement costs have decreased presumably due to the ease with which information can now be accessed and evaluated, will we see a decrease or an increase in vertical financial ownership? A large literature suggests that vertical contracting can address some of the concerns that financial ownership can address (Table-1, Mahoney(1992)). Given that financial ownership has disadvantages : bureaucratic costs, strategic costs and production costs, to what extent are these costs also associated with vertical contracts. In other words, when are vertical contracts more appropriate than ownership?