Grossman and Hart (1986) Journal of Political Economy The costs and benefits of ownership: A theory of vertical and lateral integration Grossman and Hart (1986) Journal of Political Economy Presented by Hyeonsuh Lee

Introduction Firm is composed of the assets that it owns or over which it has control. When it is too costly for one party to specify a long list of the particular rights it desires over another party’s assets, it may be optimal for that party to purchase all the rights. The owner of an asset has the residual rights of control of that asset, that is, the right to control all aspects of the asset that have not been explicitly given away by contract. There can be harmful effects associated with poor allocations of residual rights. Develop a theory of integration based on the attempt of parties writing a contract to allocate efficiently the residual rights of control between themselves.

Integration from TCE perspective The transactions will be arranged in the firm when the cost of doing this is lower than the cost of using market – Coase (1937) A contractual relationship is threatened by opportunistic and inefficient behavior in situations in which there are large amounts of surplus to be divided ex post and in which the ex-ante contract does not specify a clear division of this surplus – Klein et al. (1978) and Williamson (1979) This argument does not explain: How the scope for such behavior changes when one of the self-interested owners becomes an employee of the other owner? How can integration ever be strictly worse than non-integration – that is what limits the size of the firm? What does it mean for one firm to be more integrated than the other?

Assumption of the Model Date 0 Date 1 Ex-ante Makes relationship-specific investments (ai) – non-contractibility Ex-post Further production decisions are taken (qi) Benefits from the relationship are realized: Bi [ ai , Øi (q1, q2) ] None of the variables ai, qi, and Bi is ex ante contractible. Hence all the date0 contract can do is to allocate ownership rights or residual rights of control to the two managers. Through their influence on the distribution of ex post surplus, ownership rights will affect ex ante investment decisions.

Model Example of an electricity generating plant Firm 1: an electricity generating plant that is located to a coal mine in order to use the mine’s coal to make electricity. Let Øi (q1, q2) represent the quality of the coal delivered. Suppose that the boiler firm 1 installs to burn coal does not function well if the coal supplied is impure. -Ex ante there may be many potential impurities and it may be impossible to allow for each of these in the contract. -Ex post, however, it may be clear what the relevant impurity is. If firm 1 owns firm 2, it can, ex post, exercise its rights of control over firm 2’s assets to direct that the coal should be taken from a deposit with low ash content. If firm 2 owns firm 1, it can exercise its right of control over firm 1’s assets to direct that the boiler should be modified to accept coal with high ash content.

Model Proposition 1. If the contractibles 𝑞 𝑙 have a small effect on firm j’s benefit 𝐵 𝑗 , it is efficient for firm i to control them. Deals with the special case in which the non-contractibles are important to one party but not to another. In general, both parties will care about the non-contractibles, and as a result, each ownership structure will lead to a distortion in ex ante investments. Then “Which ownership structure leads to the least significant distortion?”

Investment distortions to the different ownership structure Firm i control Firm i has a power ex post  receive high benefit in date 1 High total benefits go together with high marginal benefits of investment  i will overinvest Firm j with low total and marginal benefits  underinvest Non-integration Gives both firms some power Lead to moderate investment levels by each THEREFORE, Firm 1 control will be desirable when firm 1’s ex ante investment is much more important than firm 2’s and when overinvestment by firm 1 under firm 1 control is a less severe problem than underinvestment by firm 1. Non-integration is desirable if a1 and a2 are both “important” in some sense, so that it is preferable to have both of them at a medium level than to have one very high and the other very low as under integration.

Application – Insurance industry Direct Writers Company Employees Agents Non-direct Writers Company Agents & Brokers Owns the list of policyholders Owns the list of policyholders This slide is originally created by Amit from last class.

Application – Insurance industry If the company owns the list, the agent will have an insufficient incentive to deliver persistent clients; that is, he will underinvest in this activity. If the agent owns the list, the company will underinvest in list building, but the agent will work hard to deliver persistent clients. Therefore, in products in which the renewal is not guaranteed and is sensitive to the agent's actions, the agent will be more likely to own the list, whereas in products in which the renewal is more certain and is less sensitive to the agent's actions, the company will be more likely to own the list.

Transaction Cost Theory Property Rights Theory Discussion Transaction Cost Theory and Property Rights Theory (Whinston, 2001) Transaction Cost Theory Property Rights Theory Similarities Theory of firm scope Same assumptions: contracts are incomplete, lock-in develops among trading partners Differences Methodologically, TCE is largely verbal Ex-post haggling costs are a major focus Levels of quasi-rents matter for integration decision Method-wise, PRT is more formal Distortions in ex ante investments are major focus Only marginal returns to investment matter for the integration decision Efficiency losses are of the same nature in all ownership structures.  ownership of physical assets affects the parties’ abilities to engage in opportunistic behavior not only in market transactions but also within the firm. Good natural experiments for testing the PRT may also provide more stringent tests of the TCE.  Firms may not always find such lock-in undesirable and so may not always integrate to avoid it, in contrast to the predictions of the TCE (but explained with the PRT).

Discussion Kim and Mahoney (2005) Property rights theory, transaction costs theory, and agency theory: An organizational economics approach to strategic management