The Choice of Organizational Form: Vertical Financial Ownership V. S The Choice of Organizational Form: Vertical Financial Ownership V.S. Other Methods of Vertical Integration Joseph Mahoney Strategic Management Journal, Vol. 13, 559-584 (1992) BADM 545 Presented by Der-Ting Huang

Main Purpose Synthesized theoretical arguments and empirical findings from vertical integration literature to identify the underlying advantages and disadvantages of choosing vertical financial ownership relative to vertical contracts.

Vertical Integration--Motives Strategic considerations Raise rivals’ costs Price squeezing Promote oligopoly Output/input price discrepancies upstream monopoly Price discrimination Uncertain costs and prices Transfer risk (supply failure) Reduce variance of profits Response to agency problems of measurement uncertainty

Vertical Financial Ownership vs Vertical Contracting When we abstract from transaction costs, knowing the motive for vertical integration cannot help us in predicting or prescribing organizational form In the absence of transaction costs, vertical contracting can replicate the advantages of vertical financial ownership. (Coase, 1960)

Agency Theory Mathematical Principal-Agent Model Unbounded rationality No difference costs between long-term contracts and hierarchy Nexus of contracts Positive Agency Theory Subset of transaction costs Organizational form matters

Advantages of Vertical Financial Ownership Transaction costs motives Predict market failure Contractual problems : asset specificity (human, physical, and site assets) Economies of scope

Advantages of Vertical Financial Ownership Profit Preemptive claims on profits between separate firms are eliminated Coordination and control Authority relationship within firms Disputes settled efficiently Audit and resource allocation Integrated firms have superior information upon which they can base allocations to their divisions Improved information enables the firm to allocate personnel to tasks more effectively Motivation Quasi-moral involvement Communication The development of a coding system which increases communication efficiencies and provides stability in operations

Disadvantages of Vertical Financial Ownership Bureaucratic costs Difficult to anticipate Internal organization more costly than the market mechanism Overestimated and not necessarily compensate for higher costs Strategic costs Loss of access to information and tacit knowledge Specialized asset  Increase sunk cost, chronic excess capacity, and low profitability Decrease strategic flexibility Production costs Cost disadvantage if not using sufficient amount of output Capital drain Capacity imbalance  higher production costs

Framework For Predicting Organizational Form Agency theory: Emphasizes information asymmetry Non-separability problem Task programmability Transaction costs approach Asset specificity (physical, human, site) Uncertainty (demand and technological)

Framework For Predicting Organizational Form Transaction costs approach (Williamson, 1979) provides insight into the key role of asset specificity, but neglects the interactive effects of measurement problems Positive agency theory emphasizes measurement costs but neglects asset specificity. Combining these two efficiency perspectives make predictions and offer prescriptions on the make-or-buy decision

Discussion Aside from the advantages of vertical financial ownership listed in the article (i.e. profit, coordination and control, audit and resource allocation, motivation, and communication), what other advantages does vertical financial ownership have? What is the difference between principal-agent research and positive agency theory? The paper points out that task programming, nonseparability, demand uncertainty, technological uncertainty, and asset specificity determine governance structure, but does not mention the role of industry here. Does industry also affect the prediction of governance structure?