The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration Oliver D. Hart, Professor of Economics at Harvard University Sanford J. Grossman, Chairman and CEO of QFS Asset Management Slides prepared by Jenna Moore, BADM 545

Overview  Research Questions: (1) What determines how vertically or laterally integrated the activities of a firm are? (2) Are there costs and benefits associated with ownership?  Conventional wisdom: incomplete contracts  non- integrated relationship  inferior outcomes (compared to complete contracts)  transactions cost-based theory (e.g., Coase, 1937) suggested that integration occurs when cost of doing so is less than cost of using the market  Klein et al. (1978) and Williamson (1979) identified probability of opportunistic behaviors  Assumes integration always leads to outcomes consistent with complete contracts

Overview  In contrast, Grossman and Hart (1986) argue that there is symmetry of control:  When residual rights are purchased by 1 party, they are lost by a 2 nd party, and this leads to distortions  Opportunistic and distortionary behaviors are not removed, only shifted

Purpose  (1) Present a theory of costly contracts  Contractual rights can be of two types: specific and residual  Sometimes it is too costly to specify all rights over assets  Alternative: one party purchases all residual rights  (2) Develop a theory of integration based on the attempt of firms to efficiently allocate residual rights of control

What is integration?  Defined by Grossman & Hart as ownership of assets (non-human: e.g., machines, inventories)  Ownership = the purchase of residual rights of control  Because contracts are incomplete, the ex post allocation of power (or control) matters  What are the costs and benefits of integration? Grossman & Hart present a model

Method  Presented a formal model of relationship between 2 firms  Relationship is either vertical or lateral  Relationship lasts over 2 periods of time: ex ante (when each manager makes relationship-specific investments) and ex post (when production decisions are made and benefits realized)  Basic assumption: no aspect of production decisions is ex ante contractible  Grossman and Hart present the model in detail, and then apply results to a firm in insurance industry

Model  Assumptions: (1) all variables are ex ante non-contractible (2) investments by managers 1 and 2 are chosen simultaneously and non-cooperatively (3)there is a competitive market in identical potential trading partners at date 0

Analysis of Optimal Contract  Optimal contract: maximizes one manager’s benefit subject to the other manager’s receiving his reservation utility  Case 1: Non-integration  Case 2: Firm 1 control  Case 3: Firm 2 control

Determining distortions associated with different ownership structures

Results  The following tradeoffs were elucidated:  When is firm 1 control desirable? When firm 1’s ex ante investment is more important than firm 2’s, and when over-investment by firm 1 is less severe problem than under-investment by firm 1  When is firm 2 control desirable? When same conditions above are satisfied for firm 2  When is non-integration desirable? When firm 1 and firm 2 investments are equally important (preferable for both to be at a medium level) *Main result: optimal ownership structure is chosen to minimize overall loss in surplus that is due to investment distortions

Application of theory to insurance industry  Grossman & Hart use their framework to analyze the determinants of who owns the list of policyholders (i.e., the only asset in this case)  They illustrate that the trade-offs between different ownership structures are the same as in their formal model

Conclusions  Sometimes it is too costly for one party to list all of the specific rights it desires over another party’s assets  In that case, ownership of residual rights may be optimal  Grossman and Hart emphasized the symmetry of control  Integration only shifts incentives for opportunistic and distortionary behaviors  Their model revealed the distortions that are due to contractual incompleteness—these distortions can prevent a party from getting the ex post return needed to balance out his ex ante investment