Vertical Restraints/contracts – try to replicate the outcome of vertical integration Non-linear pricing, p and fixed fee Exclusive dealing or exclusive territories Franchising Profit sharing or revenue sharing Quantity forcing or quantity rationing Legal issues on vertical restraints: Take away – not ok when foreclosure an issue, otherwise a per case: for example exclusive territories allowed if that is the only way the retailers provide services, if compete very aggressively in all territories no mark-up to provide services

Make versus buy Benefits of makingbenefits of buying Assure supplyefficiency Avoid regulationless managerial burden Increase profits (DM) Agency theory, incentive alignments Price Discrimination Reduce transaction costs (Williamson)

Transaction costs When transaction costs are high there is the opportunity for opportunistic behavior. One case opportunistic behavior may arise is when there is a need for specific assets And the fact that contracts are incomplete. NOTE: To be fair, the other main stream of lit to explain make versus buy decisions has to do with Agency theory, (the existence of moral hazard), hence leading to certain vertical relationships existing to provide better marginal incentives (Laffont and Martimor, for survey etc) we’ll focus here on TC.

Transaction costs For example, upstream firm may invest in assets that are valuable only in relationship with a certain downstream firm. These assets are otherwise useless. The upstream firm is at mercy of downstream firm if she invests in those assets, so she may not want to invest… So maybe if upstream firm engages in downstream production herself, those useful investments will then be made. Firms engage in vertical integration (longer term contracts) when purchasing in the spot market makes them vulnerable to opportunistic behavior … Joskow takes this literally to data

Contract Duration and Relation Specific Investments: Empirical Evidence from Coal Markets By Paul Joskow, 1985, in American Economic Review Classic paper

Research question Are relation specific investments determinants of the contract length (duration) between coal suppliers (mines) and electric utilities (downstream buyers of upstream mines)? Assumption: Risk aversion is not an important determinant of the structure of vertical relationships in this industry

Data Cross-section for year observations of coal vertical contracts Cross-sectional variation in contract length in the data: –15 % vertically integrated mines and utilities –15% spot market transactions –70% contracts with length between 1 and 5 years

Williamson (1983)’s variables of interest in coal-utility vertical relationships: Site specificity Physical asset specificity Dedicated assets Human asset specificity Left hand side: Contract duration= time agreed ex-ante to abide btw parties ->Variables defined as RHS determinants of contract length fro the empirical analysis Mine mouth Regional dummy Annual quantity

LHS = duration ->Variables defined as RHS determinants of contract length fro the empirical analysis OLS Estimates (Table 3): A Mine mouth plant has contract length predicted to be 16 years longer than those contracts of other plants Regional location matters, and east coast contracts have 3-5 shorter duration than west and mid west If Annual quantity contracted increases by an extra 1 million tons leads to 13 year increase in contract duration Shows evidence that indeed there exist appropriable quasi-rents associated with asset spec, site specif, etc in transactions between coal mines and utilities, and more for coal mines and mine mouth power plants (site specific)

Take away Buyers and sellers make longer ex-ante commitments (longer contracts) when relation specific investments are more important and rely less on repeated spot negotiations over time: –East Coast: spot market, lots of mines, homogenous coal, better railroad system –West Coast: market power, coal not homogeneous, longer term contracts

Evidence of Relation specific investments as determinants of “vertical relationships” in Motion picture industry, Chisholm,1996 Actors were long term employees before (Golden Age of Studio ), why not now? Paramount Case Role of TV Ask about contemporaneous anecdotal evidence on cross-sectional human asset specificity, type casting and correlation with “$$” and Oscars ?

Evidence of Relation specific investments as determinants of “vertical relationships” in Trucking Industry, Hubbard, What explains the ownership structure? Role of on board computers? Human capital or asset specificity? Agency theory?