1. 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, (1992)
BADM 545
Presented by Der-Ting Huang

2. 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.

3. 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

4. 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)

5. 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

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

7. 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

8. 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

9. 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)

10. 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

12. 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?