1 The Choice of Organizational Form: Vertical Financial Ownership versus Other Methods of Vertical Integration (Joe Mahoney, SMJ 1992 ) Prepared by: Enrique, Lihong, John, Jongkuk

2 Distinction between Concepts (1) Vertical Financial Ownership (VFO henceforth) Elimination of contractual or market exchanges + substitution of internal transfers within the boundaries of the firm Vertical Contracting (VC henceforth) A variety of contractual relationship, e.g. resale price maintenance, exclusive dealing, franchising, etc. VFO Mkt. Intermediate forms of VC Vertical Integration

3 Distinction between Concepts (2) Positive agency theory Vs. Mathematical principal-agent models Unavoidable agency costs among the principal-agent relationships Unbounded rationality of agents and no differential costs between long-term contracts and hierarchy Positive agency costs Vs. transaction costs (TCs) Monitoring costs, bonding costs and residual loss Ex ante TCs and Ex post TCs

4 Purpose To synthesize literature concerning VFO and VC from industrial organization and strategy To analyze the contingent relationship between VFO and VC If transaction costs and agency costs are assumed away, VFO=VC Otherwise, simple distinction between VFO and VC is inadequate To inquire into the governance structure choice given different scenarios of agency costs and transaction costs

5 Advantages of VFO Transaction costs consideration In terms of market failuremarket failure Strategic consideration In terms of competitive advantage (CA)competitive advantage (CA) Output and/or input price In terms of monopoly powermonopoly power Uncertainty in costs and/or prices In terms of stochastic elementsstochastic elements

6 To Overcome Market Failures Market failures call for “institutions of capitalism” Causes of market failures Opportunism Environment uncertainty/complexity + bounded rationality Asymmetric information Small # bargaining situation + asset specificity Advantages of VFO Profit incentive Coordination and control Audit and resource allocation Motivation Communication BackBack

7 To Strengthen CA Erect entry barriers: e.g. foreclose competitors; raise rivals’ costs; build exit barrier; use price squeezing Transfer pricing to evade regulation Maintain oligopolistic discipline Provide mobility barrier Back

8 To Smooth Price Discrepancies Successive monopoly case: to evade monopoly price by upstream firms Bilateral monopoly case: to minimize risk of rent appropriation Upstream monopoly case: to achieve efficiency in resource utilization Intermediate good monopoly case: to eliminate price discrimination incentives Back

9 To Reduce Uncertainty Uncertainty is multifaceted General theoretical agreement on the relationship b/w uncertainty and VFO Specific disagreement on the relationship b/w demand uncertainty, tech. uncertainty and VFO Empirically, the relationship b/w VFO and uncertainty is contingent on the positive agency and transaction costs

10 What can VC do? Strategic reason: entry barrier, transfer pricing and oligopolistic pricing Output/input price: control of prices Uncertainty: insure product quality and service, and alleviate problems such as tech. uncertainty, info. trading difficulty and externality ---- In the absence of transaction costs, VC can replicate the advantages of VFO!

11 The Isomorphic Nature of VFO and VC (2) ----VFO is not necessary to meet those considerations! VFO TCs consideration ?????? Strategic consideration Exclusive territories, exclusive dealing, long-term contract, vertical price-fixing, quasi-integration, tying Output/Input price Exclusive territories, requirements contract, exclusive dealing, franchise, vertical price- fixing, forcing tie-in purchase Uncertainty in prices/costs Long-term contract, Exclusive territories, vertical price-fixing, licensing

12 The Disadvantages of VFO Bureaucratic costs Implementation costs Loss of high-powered market incentives High internal costs Strategic costs Loss of access to info. and tacit knowledge Increasing sunk cost and/or chronic excess capacity Over psychological commitment Production costs Cost disadvantages without minimum efficient scale Capital drain Capacity imbalance ----VFO is not sufficient to meet those considerations!

13 To Integrate VFO, VC and TCs Dimensions of transaction costs Frequency: occasional or recurrent transactions Uncertainty: demand and technological Asset specificity: human, physical and/or site firm- specific investments Dimensions of agency costs Non-separability problems: asymmetry info. b/w output and effort Task programmability: knowledge of the transformation process

14 A Model of Governance Structure Low Task ProgrammabilityHigh Task Programmability Low Specificity High Specificity Low Specificity High Specificity Low non- separability Spot market Long-term contract Spot market Joint venture High non- separability Relational contract ClanInside contract Hierarchy

15 Contributions and Implications Theoretical contributions Propose a general theory of vertical integration strategy Fill in the research gap by incorporating the vertical governance structure comparison Integrate the agency and transaction costs theory Empirical implications Empirical study on the three variables are warranted Whether the dimensions of TCs specified here are “sufficient statistics” for predicting organization form Whether the efficiency orientation alone is adequate to predict organization form