The Choice of Organizational Form: Vertical Financial Ownership versus Other Methods of Vertical Integration (Joe Mahoney, SMJ 1992) I-Chen Wang

Distinction between Concepts Vertical Financial Ownership (VFO henceforth) Elimination of contractual or market exchanges + substitution of internal transfers within the boundaries of the firm Vertical Contracting (VC henceforth) A variety of contractual relationship, e.g. resale price maintenance, exclusive dealing, franchising, etc. VFO Mkt. Intermediate forms of VC Vertical Integration

Vertical integration strategy In the absence of agency theory and transaction costs, vertical financial ownership and vertical contracting are equivalent governance structures for achieving corporate objectives. Research question: When market mechanisms are sufficient, when intermediate forms of vertical contracting become necessary, and when vertical financial ownership becomes the preferred governance structure

To Overcome Market Failures Market failures call for “institutions of capitalism” Causes of market failures: Opportunism Environment uncertainty/complexity + bounded rationality Asymmetric information Small numbers bargaining situation + asset specificity

Vertical integration Strategic considerations Eliminate competition, e.g., oil refiner Output and/or input price discrepancies Eliminate monopoly power from each production stage, minimizing risk of appropriation Uncertain costs and prices Holding asset specificity constant, VI increase with uncertainty (TCE); but, increase in uncertainty leads to less specialized assets (Harrigan) Output measurability, shirking

ADVANTAGES OF VFO Transaction costs theory suggests the following: Profit – eliminate preemptive claims on profits between separate firms Coordination and Control – better control of opportunistic behavior due to authority relationships; disputes handled more effectively Audit and Resource Allocation – ability to audit whole firm; ability to control all resources Motivation – solidarity and clan-like emotions Communication – improved coding system

The Disadvantages of VFO Bureaucratic costs Implementation costs Loss of high-powered market incentives High internal costs Strategic costs Loss of access to info. and tacit knowledge Increasing sunk cost and/or chronic excess capacity Over psychological commitment Production costs Cost disadvantages without minimum efficient scale Capital drain Capacity imbalance ----VFO is not sufficient to meet those considerations!

To Integrate VFO, VC and TCs Dimensions of transaction costs Frequency: occasional or recurrent transactions Uncertainty: demand and technological Asset specificity: human, physical and/or site firm-specific investments Dimensions of agency costs Non-separability problems: asymmetry info. b/w output and effort Task programmability: knowledge of the transformation process

Proposition Non-separability, programmability (agency theory Information asymmetry), specificity (TCE) are three factors to suggest the vertical ownership decision Low task programmability High task programmability Low specificity High specificity Low non-separability Spot market Long-term contract Joint venture High non-separability Relationship contract Clan (hierarchy) Inside contract Hierarchy

Contributions and Implications Theoretical contributions Propose a general theory of vertical integration strategy Fill in the research gap by incorporating the vertical governance structure comparison Integrate the agency and transaction costs theory Empirical implications Empirical study on the three variables are warranted Whether the dimensions of TCs specified here are “sufficient statistics” for predicting organization form Whether the efficiency orientation alone is adequate to predict organization form