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 Jingya You

Introduction Firm is composed of the assets (e.g., machines, inventories) that it owns. Contractual rights: specific rights and residual rights There can be harmful effects associated with an inappropriate allocation of residual rights. Develop a theory of integration based on the attempt of parties in writing a contract to allocate efficiently the residual rights of control between themselves.

Transaction Cost Theory Coase (1937) Klein et al. (1978) & Williamson (1979) A contractual relationship will be plagued by opportunistic when 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 and inefficient behavior.

Transaction Cost Theory Two questions are still unsolved: How can integration ever be 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 another?

Assumption of the Model Ex ante (Date 0) Ex post (Date 1) Relationship-specific investments (ai) Further production decisions (qi) Benefits from the relationship Bi [ ai , Øi (q1, q2) ] None of the variables ai, qi, and Bi is ex ante contractible. After the contract is signed, a1 and a2 are chosen simultaneously and noncooperatively by managers 1 and 2. At date 1, the owner of firm i has the right and power to choose qi.

An Example Firm 1 is an electricity generating plant that is located next to a coal mine in order to use the mine's coal to make electricity. 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: it may be clear what the relevant impurity is (e.g., high ash content). If firm 1 owns firm 2, it can 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.

Proposition 1 If the noncontractibles ql (l=1 or 2) have a small effect on firm j’s benefit Bj, it is efficient for firm i to control them. It deals with the special case in which the noncontractibles are important to one party but not to another. In general, both parties will care about the noncontractibles, and, as a result, each ownership structure will lead to a distortion in ex ante investments. Which ownership structure leads to the least significant distortion?

Ownership Structure Firm 1 control Firm 1 has a power ex post → receive high benefit in date 1 High total benefits go together with high marginal benefits of investment → 1 will overinvest Firm 2 with low total and marginal benefits → underinvest 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.

Ownership Structure Nonintegration Gives both firms some power Lead to moderate investment levels by each Nonintegration 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.

An Application in Insurance Industry ? The list of clients Agent Company Back-loaded commission Two types of noncontractibles Noncontractibles that can hurt the agent if the company owns the list. Noncontractibles that can hurt the company if the agent owns the list.

An Application in Insurance Industry Company Agent The list of clients The list of clients The agent will have an insufficient incentive to deliver persistent clients; that is, he will underinvest in this activity. The company will underinvest in list building, but the agent will work hard to deliver persistent clients.

An Application in Insurance Industry Company Agent The list of clients The list of clients The renewal is more certain and is less sensitive to the agent's actions (e.g., whole life insurance). The renewal is not guaranteed and is sensitive to the agent's actions (e.g., property-casualty insurance).

Discussion Nonintegration is desirable if a1 and a2 are both “important” in some sense. How to assess or compare the importance of each party’s investment ex ante, especially under high uncertainty? There is only one asset in the example of selling insurance. What if there are multiple assets? For example, two parties possess complementary assets. How to distribute rights between the parties to maximize their investment incentives?