Chapter 2
Firms and Markets
School of Economics and Business
Administration
Universidad de Navarra
Theories of the firm
 Neoclassical Theory
 Contractual Theory
 Agency Theory
 Behavioral Theory
Structure of the chapter
 2.1. Efficiency and limits of the market
 2.2. Transaction Costs and the holdup problem
 2.3. Behavioral approach to the holdup problem
 2.4. Vertical and Horizontal Boundaries of the Firm
2.1.1. Efficiency and limits of the market
 The Neoclassical model is useful to study how the
price system may achieve a high degree of
coordination without the need for a central planner.
 Basic Assumptions.



Assumption A (Perfect Competition)
Assumption B (Full Rationality)
Assumption C (Perfect Information)
2.1.1. Efficiency and limits of the market
 Assumption A (Perfect Competition)
A market exists for each good or service, and markets participants
(consumers and producers) are in large number so that they do not affect
the market outcomes.
 Assumption B (Full Rationality)
B1) Agents have unlimited computational abilities.
B2) Agents are self-interested and maximize an objective function referred
to as a utility function.
 Assumption C (Perfect Information)
Agents have perfect information on prices and other agents' preferences
(consumers) and technologies (producers).
2.1.1. Efficiency and limits of the market
 An allocation for the economy consists of feasible
consumption and production plans for each agent.
 An allocation is Pareto efficient if there is no other
allocation that is strictly preferred by some agents
and for which the other agents are indifferent.
2.1.1. Efficiency and limits of the market
 The next theorem holds under Assumptions A, B
and C.
Fundamental Welfare Theorem.
The allocation obtained in a competitive equilibrium
is efficient.
2.1.1. Efficiency and limits of the market
 Informational efficiency of market prices (Hayek
1945).
In a competitive equilibrium prices capture all the
relevant information at a given time.
Example I.
Decision to buy a bottle of wine.
2.1.1. Efficiency and limits of the market
 The selection of wines… you are offered a bottle of
wine by your favorite supermarket. Two are left…
2.1.1. Efficiency and limits of the market
 2006 Oreana Red Table Wine from California
2.1.1. Efficiency and limits of the market
 2006 Oreana Red Table Wine: A soft wine
with voluptuous black cherry and blackberry
fruit, plus layers of chocolate and spices
suggestive of cinnamon, mint and more.
Powerful and complex, yet open and accessible.
Price: $10.00
2.1.1. Efficiency and limits of the market
Example II.
A PC sold in the Soviet Union in 1989 for 145 000$ to
an industrial buyer was sold for 3 500$ in the US at the
same time.
2.1.1. Efficiency and limits of the market
 Discussion Pareto efficiency.
Twice a year Real Madrid and FC Barcelona played
together the “Clasico”. A lay person can barely think of
getting a ticket for this game even though this person is
ready to pay a high price. Why football clubs do not
use a market mechanism to assign tickets to people
who value them most?
2.1.2. Market failures






Imperfect Competition
Increasing Returns to Scale
Externalities
Public Goods
Asymmetry of Information
Search Costs
2.1.2. Market failures
Imperfect Competition
 Imperfect Competition (The double marginalization problem)
- 2 monopolies: producer firm and distributor firm that fix the
final price of the product.
- Assumer that the producer firm is a monopoly (Monopoly 1)
with costs C(q1) = cq1, 0 < c < 1 so that CM = c.
2.1.2. Market failures
Imperfect Competition
- Monopoly 1 sells the product for a price r to Monopoly 2 that
do not incur transformation costs and distribute the product at a
price p, the inverse demand function is as follows:
p = 1-q and q is the total demand for the final product.
2.1.2. Market failures
Imperfect Competition
 In short, we face the following situation:
Producer
(Monopolist 1)
q1
r
Distributor
(Monopolist 2)
q2
Cost
function:
cq1
Transformation
cost: 0
p
Consumers
Demand:
p=1-q
2.1.2. Market failures
Imperfect competition
r
p
Consumers
Monopoly
relationship
Monopoly
relationship
2.1.2. Market failures
Imperfect competition
Vertical integration
Internal
bargaining
p
Monopoly
relationship
Consumers
- Cooperation and negotiation implement a better
solution than competition.
2.1.2. Market failures
Imperfect Competition
 Solution:
- Monopoly 1 knows that Monopoly 2 maximizes its
profit given the price r chosen by the first monopolist.
- Monopoly 2 solves the following problem:
Max pq2-C(q2) ≡ Max (1-q2-r)q2
Where q is the quantity of the product sold to the market.
CPO: q2 = (1-r)/2
r=1-2q2
2.1.2. Market failures
Imperfect Competition
 Then, Monopoly 1 solves the following
maximization problem, where q1 is the quantity
sold by Monopoly 1 to Monopoly 2, i.e. q1 = q2 =
q (equilibrium condition).
Max rq - C(q) ≡ Max (1-2q)q - cq
FOC: q* = (1-c)/4
2.1.2. Market failures
Imperfect Competition
 If the 2 firms integrate vertically, the production
will be chosen so as to maximize joint profits.
Max pq - C(q) ≡ Max (1-q)q - cq
FOC: q* = (1-c)/2
2.1.2. Market failures
Imperfect Competition
 Vertical integration implements a better solution.
With vertical integration the quantity produced is
higher:
qI = (1-c)/2 > q* = (1-c)/4, y
pI = 1 - qI = (c+1)/2 < p* = 1 – q* = (c+3)/4
so that: p*> pI
πI = 1/4 × (1-c)² and πNI = 3/16 × (1-c)²
2.1.2. Market failures
Externalities
 Externalities are positive or negative effects that one
economic agent’s actions have on another’s welfare that are
not regulated by the system of prices..
Examples of positive externalities: wireless internet
connection of your neighbors or negative externalities:
activities that increase the level of pollution.
2.1.2. Market failures
Externalities
 Exercise
- The Steel Mill has the following cost function:
Cs(s) = s²/2 so that MCs = s where s is the production of steel.
The steel mill produces a negative externality given that it
increases the marginal cost of a fishery located close by.
- The fishery has the following cost function:
Cf(f) = f²/2 + f×s/2 so that MCf = f + s/2
- Per unit prices of steel and fish are ps = pf = 10.
2.1.2. Market failures
Externalities
 Exercise Steel Mill and Fishery
Steel mill
River
Marginal cost: s
Fishery
Marginal cost : f+s/2
2.1.2. Market failures
Externalities
 Solution.
- Competitive equilibrium:
Max π(q) = pq - C(q)
The steel mill and the fishery chose their production levels s
and f so that prices are equal to marginal costs:
ps = CMs so that 10 = s
pf = CMf so that 10 = f + 5 then f = 5
These production levels imply the following levels of profit: πs
= 50 y πf = 12.5 so that total profits reach 62.5.
2.1.2. Market failures
Externalities
 Solution.
- This solution is not efficient since too much steel is
produced whereas too few fishes are sold. Consider the
choice of a central planner (or the director of an integrated
firm) that maximizes joint profits:
Max π(s,f) ≡ ps × s + pf × f -[Cs(s) + Cf(f) ]
Max 10(s + f) – [s²/2 + f²/2 + f × s/2]
FOC: s = f = 20/3 ≃ 6.7
π(20/3,20/3) ≃ 66.7 > 62.5
2.1.2. Market failures
Externalities
 However, we have to take into account that the profit of the
steel mill is inferior to its initial level of profit since:
πs(20/3) = 44.4 < 50. The fishery will have to compensate the
steel mill in order to ensure that the latter firm has incentives to
be part of the integrated firm.
 There is a solution to this bargaining problem since the
increase in the profit of the fishery (22.2 - 12.5 ≃ 9.7) is larger
than the reduction in the profit of the steel mill (50- 44.4 ≃5.6)
2.1.2. Market failures
Search costs
 The Neoclassical model assumes (Assumption B1) that there
is no search costs since every agent knows the price, the location
of goods and services to be exchanged.
- It is costless to gather and process information about possible
trade opportunities.
 It is also assumed that buyers and sellers meet automatically
so that there is not matching costs.
- It is costless to find buyers or sellers for current prices.
Examples: distribution in supermarkets, internet transactions.
2.1.3. Coordination by management
 Transactions undertaken within firms are most of the time
not regulated by prices but by a system of hierarchical
relationships where the manager elaborates plans that
coordinate the actions of the members of the organization.
 The role of the manager is to ensure that there is coordination
among all workers and groups of workers, that individual
incentives are aligned with those of the organization, and that the
plan correctly adapts to changes in the environment.
2.1.3. Coordination by management
 The manager must determine which should be the
transactions that are centralized inside the organization and
which are the plans that are decentralized through the market
mechanism. In addition, the manager has to design the proper
communication channels, both from management to workers
and conversely.
2.1.3. Coordination by management
 Transfer pricing at Bellcore.
- Bellcore is the research division of AT&T (American
Telephone and Telegraph). In the late 1980s Bellcore faced a
situation in which its best engineers were typing their letters,
memos and research documents with typists outside the
organization while at the same time Bellcore was firing typists
because of insufficient work.
- This misallocation of personnel was due to an error in the
internal accounting system. The transfer price for typing a
research page reached the (unreasonable) value of 50$ per page.
2.1.3. Coordination by management
 Transfer pricing: price that regulates transactions between
divisions of the same.
 Example: Oil company with an extraction division and a
refining division or technology transfer between divisions of a
multinational.
Extraction division
P = Oil transfer price
Refining division
Ishikawa, 1962
2.1.3. Coordination by management
Communication and quality circles
A quality circle is a group of volunteers
composed of workers that meet to exchange ideas to
improve the quality of the products and of the
production process.
Developed by Kaoru Ishikawa in Japan in 1962.
2.1.3. Coordination by management
Communication, codes and corporate culture
Example: Universidad de Navarra
“This an OP course of 4.5 ECTS for IDE, IDM,
GML and GEL students at UN.”
Structure of the chapter
 2.1. Efficiency and limits of the market
 2.2. Transaction Costs and the holdup problem
 2.3. Behavioral approach to the holdup problem
 2.4. Vertical and Horizontal Boundaries of the Firm
2.2. Transaction costs
 The Transaction costs theory is based on the idea that
contracts are incomplete so that coordination and motivation
costs arise that can be reduced by completing transactions
inside an organization.
- Coordination costs: before signing the contract
- Motivation costs: after signing the contract
2.2.1. Asset specificity
 Definition: an asset is specific if it is much more valuable
in a given transaction than in the best alternative available. In
the presence of specific assets, the terms of a transaction are
determined by bilateral bargaining, (“fundamental
transformation”, Williamson 1985).
 For example, the producer of aluminum realizes a
specific investment when designing its plant so as to use a
certain type of bauxite.
2.2.1. Asset specificity
 Example I: the producer of aluminum.
Bauxite
Aluminum
Consumers
 Example II: investment in studying the lecture notes of a
professor. Would you pass the exam of the same course in
another university?
2.2.1. Asset specificity

Different types of specificity.
1. Site specificity. This refers to assets that are located side-by-side to
save on production, transportation or inventory costs. Examples:
steel production, oil.
2. Physical asset specificity. This refers to assets with physical
characteristics that are designed for a specific transaction.
Examples: mold, perfumes.
3. Dedicated asset. It corresponds to an investment in plants and
equipment that are completed in order to satisfy the demand of a
particular client. Example: car manufacturer.
4. Specific human capital.
2.2.2. Quasi-rents
 Definition: the rent associated to an input is the difference between
the revenues obtained by the owner of the input and the minimum
revenue necessary to make sure that he will supply the input.
 Definition: the quasi-rent is the difference between the rent
associated to a specific transaction and the rent obtained in the best
alternative available.
2.2.2. Quasi-rents
 Assume a firm A that supplies rear mirrors to Volkswagen. In order
to produce these mirrors the firm has to make an investment that
costs I.
- Firm A produces rear mirrors for Volkswagen and its cost
function is: CA(q) = I + cq, where c > 0. Also, we know that
expected yearly sales reach million units.
- If firm A signs a contract with Volkswagen to supply 1 million
rear mirrors pear year at a price PV, the rent of firm A is equal to its
profit.
2.2.2. Quasi-rents
 Example: Firm A – Volkswagen. Alternative option for firm A: Pm,
where Pm > c. I = 8500000€, c = 3€, Pm = 4€ < PV = 12€.
Compute the rent and the quasi-rent associated to the specific
investment of firm A.
RA = 1000000 × (PV - c) – I = 500 000 €
QRA = 1000000 × (PV - Pm) = 8 000 000 €
If the price of the best alternative was equal to the price offered by
Volkswagen (Pm = PV), then the quasi-rent would be equal to zero.
2.2.3. The “holdup” problem
 The holdup problem appears when a party that does not invest in a
specific asset behaves opportunistically modifying the terms of the
transaction.
 The holdup problem is based on the following two deviations of
the neoclassical model.
1. Asset specificity (imperfect competition).
2. Incomplete contracts (agents are boundedly rational).
2.2.3. The “holdup” problem
 Example: Volkswagen.
Volkswagen knows that it can offer a price between Pm y PV.
Then, we are in a case of bilateral bargaining where Volkswagen
has the negotiation power.
- For example, firm A accepts the new price PV = 10€ instead of
12€ since PV > Pm.
- The problem is that for PV =10€, firm A incurs losses since its
rent is negative in that case:
RA =(10-3)×1000 000 - 8 500 000= -1 500 000€
2.2.3. The “holdup” problem
 Exercise: Novartis hires a research lab to develop a medicine
to cure the bird flu.
- In the contract, it is stated that the firm Novartis pays the lab
a “royalty” of 20% over sales.
- Sales are estimated to be 5 millions € in the lifetime of the
medicine.
- For the lab, the cost of the study is 950 000 € and the lab can
sell its result to another firm for 120 000€.
2.2.3. The “holdup” problem
 Exercise: Novartis. Once the study has been completed, the
firm communicates to the lab that a competitor argues that the
new medicine does not comply with an existing patent. As a
result, legal costs are expected by the firm. Then, Novartis
renegotiates the contract with the research lab offering a lower
royalty of 10%.
a) What is the expected rent for the research lab?
R = 0,2×5000000 - 950000= 50 000$
b) What is the quasi-rent for the lab?
QR=50000 - [120000 - 950000] = 880 000$
2.2.3. The “holdup” problem
c) Will the lab accept the renegotiation of the contract?
Yes given that the level of losses of the lab are:
π = 0,1×5000000 – 950000 = - 450000€.
In the alternative option the losses would be 830000€.
d)
Given your previous answers. Do you think the research
lab will be willing to invest in the specific asset ?
If the managers of the research lab anticipates that the
renegotiation of the contract is very likely then they may
decide not to complete the transaction with the
pharmaceutical firm.
2.2.3. The “holdup” problem
 Exercise: General Motors-Fisher Body.
The case of General Motors (GM) and its supplier of bodies
(Fisher Body (FB)).
1) In 1919, GM decides to introduce steel bodies to substitute
the bodies made of wood. GM asks FB to produce these
new bodies.
2) The new steel bodies generate a specific investment for FB
in order to adapt its production plant to the new needs of
GM.
3) FB anticipates a possible holdup problem with GM fearing
that the car manufacturer will pressure FB to lower the
price of the bodies in the future (after signing the contract).
2.2.3. The “holdup” problem
 Exercise: General Motors-Fisher Body.
1. What is the solution in order to ensure that FB will complete the
transaction with GM?
GM and FB signed the following contract:
- A 10-year contract under which GM buys 60% of FB without taking
the control.
- If FB to another car manufacturer at a lower price then it will have to
reduce its prices to GM as well.
- FB unique supplies of GM and the contract determines the prices of
bodies as follows: p = Cv×(1+0.176).
2. Is this contract complete? What are the problems associated to this
contract?
2.2.3. The “holdup” problem
 Exercise: SPSS.
- A software firm holds the copyright for the software SPSS. This firm
hired an independent programmer to write an application of SPSS.
- The programmer estimates that the development of this application
will require 200 hours that he could spend working on other projects
paid 3000 € per hour. – The programmer also estimates that the total
sales of the application will reach 160000 €. The programmer signs
the following contract:
- Initial payment of 10000 € before starting the project.
- “Royalties” of 50% of total sales of the application.
1. Determine the expected rent of the programmer.
RP = 10000 + (1/2) × 160000-60000 = 30000€
2.2.3. The “holdup” problem
 The alternative use of the SPSS application is zero (Dedicated asset)
2. What is the quasi-rent of the transaction once the contract ahs been signed
and the initial payment of 10000€ has been made?
QRP = 30000 - (10000 - 60000) = 80000€
An employee of the software firm develops (concurrently) a similar SPSS
application. The firm informs the programmer explaining that the total sales of
his application will be reduced to 50000 €.
RP = 10000 + (1/2) × 50000 – 60000 = -25000€
3. What is the minimum percentage of royalties (ρ) accepted by the
programmer in order to avoid the software firm to sell the alternative
application to the market?
R_P = 10000 + ρ160000- 60000 = 10000 + (1/2)50000 - 60000 ⇒ ρ = 15.625%
2.2.4. Vertical integration as a solution
to the “holdup” problem
 Definition: vertical integration consists in the control by
a single entity of successive steps of the production or
distribution process of a product or service.
1.
Differences in government.
The role of hierarchy and corporate culture to manage conflicts.
2.
Repeated relationship.
2.2.4. Transaction costs and the “holdup” problem
 There exist 4 cases in which the holdup problem
increases transaction costs:
1.
Negotiations and renegotiations of the contract
2.
Investments to improve the bargaining position
3.
Distrust
4.
Reduction in investment
Structure of the chapter
 2.1. Efficiency and limits of the market
 2.2. Transaction Costs and the holdup problem
 2.3. Behavioral approach to the holdup problem
 2.4. Vertical and Horizontal Boundaries of the Firm
The “holdup” problem
 The holdup problem appears when a party that does not invest in a
specific asset behaves opportunistically modifying the terms of the
transaction.
 The holdup problem is based on the following two deviations of
the neoclassical model.
1. Asset specificity (imperfect competition).
2. Incomplete contracts (agents are boundedly rational).
Vertical integration as a solution to the
“holdup” problem
 Definition: vertical integration consists in the control by
a single entity of successive steps of the production or
distribution process of a product or service.
1.
Differences in government.
The role of hierarchy and corporate culture to manage conflicts.
2.
Repeated relationship.
Transaction costs and the “holdup” problem
 There exist 4 cases in which the holdup problem
increases transaction costs:
1. Negotiations and renegotiations of the contract
2. Investments to improve the bargaining position
(Example: ETXE-TAR
3. Distrust
4. Reduction in investment
)
Structure of the chapter
 2.1. Efficiency and limits of the market
 2.2. Transaction Costs and the holdup problem
 2.3. Behavioral approach to the holdup problem
 2.4. Vertical and Horizontal Boundaries of the Firm
2.3. Behavioral approach to the holdup problem
 The behavioral theory of the firm is characterized by
the following assumption:
Assumption B2 (Social preferences)
Agents do not only care about their own material
payoffs but also about others' payoffs and actions.
2.3. Behavioral approach to the holdup problem
 Investment game.
Player A (investor) receives an amount of money S (10
euros) and he makes a transfer x in [0,10] to Player B
(trustee). If Player A transfers x then Player B receives 3x
and can send back any y in [0,3x]. We run two treatments:
the proximity treatment and the market (anonymous)
treatment.
 Represents a possible holdup situation where the
investment of Player A (e.g. Fisher Body) can be captured
in its totality by Player B (e.g. General Motors).
2.3. Behavioral approach to the holdup problem
Definition. Corporate culture is a system of shared values and norms
that define appropriate attitudes and behaviors for organizational
members.
Organization
Proximity
Corporate Culture
Social Preferences
(Fairness, equity, altruism, envy)
2.3. Behavioral approach of the firm
 Behavioral theory says that opportunistic behaviors and
the costs that they entail (e.g. holdup problem) can be
reduced when transactions are completed inside the
organization.
 However, in some circumstances social preferences can
have a negative effect on transaction costs. Trust
generated inside an organization may increase
influence costs, corruption.
 Definition. Influence costs are the costs incurred in
attempts to influence others’ decisions for self-interested
motives and in attempts to counter such influence
activities by others.
2.3. Behavioral approach of the firm
 A possible strategy to limit influence costs is to render
difficult the access to sensitive information like employees’
wages. This can be done using hierarchies.
 Another strategy consists in limiting the time for bargaining
and discussing wage increases and promotion. As a general
principle, Milgrom and Robert (1992) assert that:
“... rent distributing decisions should be made once and for
all.”
2.3. Behavioral approach of the firm
 Example I. Law partnerships. Paying everybody the
same eliminates influence costs but reduces the incentives
to exert high levels of effort and may push the best
lawyers to leave to Law firms that provide better
incentives in order to fully exploit their talent
 Example II. Airlines. Airlines companies separate
decisions related to efficiency from the decisions affecting
the distribution of profits. For example, managers do not
assign cabin attendants to flights, they just make sure that
there is a sufficient number of cabin attendants to cover all
flights. Rather, cabin attendants chose their flights in order
of seniority.
2.3. Behavioral approach to the holdup problem
 Another important mechanism that organizations can use to
align employees and shareholders interests is to implement
compensation systems that depend on the global
performance of the firm.
 Example. Senior management at Quantum, the disk drive
manufacturer in Milpitas, California, demonstrates its
commitment to teamwork by placing all employees, from the
CEO to hourly workers, on the same bonus plan, tracking
everyone by the same measure -- in this case, return on
total capital.
2.3. Behavioral approach of the firm
 Envy and proximity.
“We envy those who are near us in time, place, age or
reputation.” (Aristotle).
 Competitive envy.
“The desire to improve one’s relative status is the engine that
drives the economic train (…). Envy [is] functional in promoting
hard work, accumulation and economic growth.” (Marglin 2002)
 Destructive envy.
“A person prefers that others have less, and he might even
sacrifice a little of his own wealth to achieve that end”
(Zeckhauser 1991)
2.4. Vertical and horizontal boundaries of the firm
 Definition. Vertical integration consists in the
control by a single entity of several steps in the
production or distribution of a product or service.
Raw materials
Parts
Final Assembly
Distribution
2.4. Vertical and horizontal boundaries of the firm
 Definition. Horizontal integration consists in the
absorption into a single firm of several firms involved
in the same level of production or distribution.
Raw materials
Raw materials
Parts
Parts
Final Assembly
Final Assembly
Distribution
Distribution
2.4. Vertical boundaries of the firm
Technical and agency efficiency
Definition. Technical efficiency measures the extent to
which the production is cost minimizing.
Definition. Agency efficiency measures the extent to
which transaction costs are minimized.
ΔT(k) = TI – TNI > 0 & ΔT’(k)<0
ΔA(k) = AI – ANI & ΔA’(k)<0
2.4. Vertical boundaries of the firm
 Technical and agency efficiency as a function
of asset specificity (k).
ΔC(k)= ΔT(k) + ΔA(k)
2.4. Vertical boundaries of the firm
 Economies of scale and of scope. An increase in economies
of scale (average costs decrease with production) or scope
(average costs decrease with variety of production) tends to
reduce the likelihood of vertical integration since the relative
gains of the organization are lower in that case.
C
C
A
k*
k**
T
k
2.4. Vertical boundaries of the firm
 Product demand. As the demand for the firm’s product
increases the firm will be in a better position to take advantages
of economies of scale. As a result, an increase in the scale of
operations tends to increase the likelihood of vertical integration.
 Then: ΔT and ΔC moves leftwards.
 As a general principle, a firm with different products will be
more likely to be vertically integrated in the businesses in which
its scale of production is larger.
2.4. Vertical boundaries of the firm
Empirical evidence of Williamson’s theory
 Monteverde and Teece (1982): US car industry, they try to
show evidence of the effect of asset specificity on vertical
integration.
 They study investments in “know-how” of suppliers of
different types of components (motors, bodies, electronic
devices).
 Result: positive relationship between complexity of the design
of the component and related quasi-rents so that vertical
integration is more likely for the supply of complex components.
Other example: Airspace industry.
Chapter 2
Firms and Markets
School of Economics and Business
Administration
Universidad de Navarra
Economics of organizations
 Assumption A (Perfect Competition)
A market exists for each good or service, and markets participants
(consumers and producers) are in large number so that they do not affect the
market outcomes.
 Assumption B (Full Rationality)
B1) Agents have unlimited computational abilities.
B2) Agents are self-interested and maximize an objective function referred
to as a utility function.
 Assumption C (Perfect Information)
Agents have perfect information on prices and other agents' preferences
(consumers) and technologies (producers).
Structure of the chapter
 2.1. Efficiency and limits of the market
 2.2. Transaction Costs and the holdup problem
 2.3. Behavioral approach to the holdup problem
 2.4. Vertical and Horizontal Boundaries of the Firm
2.4. Vertical and horizontal boundaries of the firm
 Definition. Vertical integration consists in the control by a single
entity of several steps in the production or distribution of a product
or service.
Raw materials
Parts
Final Assembly
Distribution
 Definition. Horizontal integration consists in the absorption into a
single firm of several firms involved in the same level of production
or distribution.
2.4. Vertical boundaries of the firm
Technical and agency efficiency
Definition. Technical efficiency measures the extent to
which the production is cost minimizing.
Definition. Agency efficiency measures the extent to
which transaction costs are minimized.
ΔT(k) = TI – TNI > 0 & ΔT’(k)<0
ΔA(k) = AI – ANI & ΔA’(k)<0
2.4. Vertical boundaries of the firm
 Technical and agency efficiency as a function
of asset specificity (k).
C
ΔC(k)= ΔT(k) + ΔA(k)
C
A
T
k*
k
2.4. Vertical boundaries of the firm
 Economies of scale and of scope. An increase in economies
of scale (average costs decrease with production) tends to
reduce the likelihood of vertical integration since the relative
gains of the organization are lower in that case.
C
C
A
T
k*
k
2.4. Vertical boundaries of the firm
 Economies of scale and of scope. An increase in economies
of scale (average costs decrease with production) tends to
reduce the likelihood of vertical integration since the relative
gains of the organization are lower in that case.
C
C
A
T
k* k**
k
2.4. Vertical boundaries of the firm
 Product demand. As the demand for the firm’s product
increases the firm will be in a better position to take advantages
of economies of scale. As a result, an increase in the scale of
operations tends to increase the likelihood of vertical integration.
 Then: ΔT and ΔC moves leftwards.
 As a general principle, a firm with different products will be
more likely to be vertically integrated in the businesses in which
its scale of production is larger.
2.4. Vertical boundaries of the firm
Empirical evidence of Williamson’s theory
 Monteverde and Teece (1982): US car industry, they try to
show evidence of the effect of asset specificity on vertical
integration.
 They study investments in “know-how” of suppliers of
different types of components (motors, bodies, electronic
devices).
 Result: positive relationship between complexity of the design
of the component and related quasi-rents so that vertical
integration is more likely for the supply of complex components.
Other example: Airspace industry.
2.4. Vertical boundaries of the firm
Empirical evidence of Williamson’s theory
 Monteverde and Teece (1982): US car industry.
General Motors &
Ford
Component with high
engineering effort
Probability of vertical de
Integration
Specific component
+ 82%
+ 15%
2.4. Vertical boundaries of the firm
Vertical integration and asset ownership
 Grossman, Hart y Moore (GHM) consider the effect of asset
ownership on the incentives of the parties implied in a transaction
to complete specific investments.
 Definition: Asset ownership gives the owner the right to
dispose of the asset as he wants within the limits of the law.
 In the case of incomplete contracts, asset ownership influences
the decision of a firm to integrate vertically given that it affects
decisions to invest in specific assets.
2.4. Vertical boundaries of the firm
Vertical integration and asset ownership
 Example: a printing firm (firm 1) and a publisher (firm 2). The
two firms are separated entities that are linked by a long term
contract that is incomplete since it does not take into account all
contingencies.
Printer
Firm 1
Publisher
Firm 2
Consumers
2.4. Vertical boundaries of the firm
Vertical integration and asset ownership
 Situation: the printing firm has invested in a software that
permit documents to be printed according to the publisher
requirements. This is a specific investment and it generates a
holdup problem. Why?
 Two possibilities for vertical integration according to which
form owns the assets.
1- Forward integration: the supplier owns both firms. The printer
(firm 1) is the sole owner of both the printing and publishing
firms.
2- Backward integration: the client owns both firms. The publisher
is the sole owner of both firms.
2.4. Vertical boundaries of the firm
Vertical integration and asset ownership
 1- Forward integration. In that case, the printer does not
worry about being heldup since he owns the assets and will be
able to capture all the value associated to the specific
investment .(e.g. Fisher Bodies - General Motors).
Printer
Firm 1
Publisher
Firm 2
2.4. Vertical boundaries of the firm
Vertical integration and asset ownership
 1- Forward integration. In that case, the printer does not
worry about being heldup since he owns the assets and will be
able to capture all the value associated to the specific
investment .(e.g. Fisher Bodies - General Motors).
Printer
Firm 1
Publisher
Firm 2
2.4. Vertical boundaries of the firm
Vertical integration and asset ownership
 2- Backward integration. In that case, the printer will be even
less willing to invest in specific assets than in the case of nonintegration or forward integration. This is the case since then
the publisher has all the bargaining power to capture all the
value associated to the specific investment.
Printer
Firm 1
Publisher
Firm 2
2.4. Vertical boundaries of the firm
Vertical integration and asset ownership
 2- Backward integration. In that case, the printer will be even
less willing to invest in specific assets than in the case of nonintegration or forward integration. This is the case since then
the publisher has all the bargaining power to capture all the
value associated to the specific investment.
Printer
Firm 1
Publisher
Firm 2
2.4. Vertical boundaries of the firm
Vertical integration and asset ownership
 GHM’s theory predicts that integration is better
when one of the parties’ specific investments are
more sensitive to asset ownership.
Ownership should be transferred to the party
that is most exposed to opportunism.
 In the case of the printer and publisher, if
investments in a customized software are highly
valuable then it is preferable for the printer to own
the two businesses.
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Long term contract and implicit contract
- An implicit contract is an tacit and informal
agreement that does not appear in any legally
enforceable document.
-
In that case, parties may decide to write long term
contracts to sustain agreements that are not legally
enforceable. It is possible given that one party can
threaten the other with future punishments in case of
no compliance of the initial agreement.
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Example (long term contract).
- A firm A provides each year quality controls to firm B.
- The two firms earn 1 million euros each year as a result of this
transaction.
- To complete transactions with other parties would imply a
profit of 900 000 € / year (specific transaction).
- Not completing the quality control, firm A increase benefits
by 500 000 € / year. However, firm B detects such behavior
and the relationship between the two firms will end.
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Example (long term contract).
a) Determine the level of interest rate under which firm A
decides to complete the quality control.
1000000[1+1/(1+r)+((1/(1+r))² + ...)
≥ 1500000 + 900000[1/(1+r) + (1/(1+r))² + ...)
r < 20%
- Examples of long term contracts: Kereitsus in Japon
(Mitsubishi)
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Business alliances
-
-
In a business alliance, several firms agree to collaborate
in a project and exchange information and other inputs
(General Motors – Toyota in the 80s).
Similar to market transactions as firms are independent
entities, but a business alliance implies a greater level of
cooperation, coordination and information transmission
than in a market transaction making the alliance closer to
a situation of vertical integration.
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Business alliances
-
Examples: car industry, share information to sell in new markets
(e.g. China).
Factors to choose business alliances.
1. Writing a complete contract is difficult.
2. Specific investments.
3. A party may not complete a transaction alone (knowledge,
plant, machinery…).
4. The conditions that create the need for the transaction are
transitory so that a merger is not a good alternative.
5. Law may prevent a firm to operate in a country without a local
partner, e.g. in China.
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Franchising
-
-
In a franchise agreement, the franchisee operates a business using
the brand of a franchisor and frequently buys inputs or final
products to the franchisor.
Examples: Fast food (McDonalds, Burger King, Telepizza).
Automobile industry (car dealerships).
The payment scheme is usually a fixed payment plus a percentage
of sales.
It is not a case of vertical integration since the franchisee is not
the employee of the franchisor.
Franchising implies holdup problems and agency costs.
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Franchising puzzle
Franchising among gas stations that provide repair
services is more frequent that for gas stations that do
not.
Why?
Structure of the chapter
 2.1. Efficiency and limits of the market
 2.2. Transaction Costs and the holdup problem
 2.3. Behavioral approach to the holdup problem
 2.4. Vertical and Horizontal Boundaries of the Firm
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Long term contract and implicit contract
- An implicit contract is an tacit and informal
agreement that does not appear in any legally
enforceable document.
-
In that case, parties may decide to write long term
contracts to sustain agreements that are not legally
enforceable. It is possible given that one party can
threaten the other with future punishments in case of
no compliance of the initial agreement.
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Business alliances
-
-
In a business alliance, several firms agree to collaborate
in a project and exchange information and other inputs
(General Motors – Toyota in the 80s).
Similar to market transactions as firms are independent
entities, but a business alliance implies a greater level of
cooperation, coordination and information transmission
than in a market transaction making the alliance closer to
a situation of vertical integration.
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Franchising
-
-
In a franchise agreement, the franchisee operates a business using
the brand of a franchisor and frequently buys inputs or final
products to the franchisor.
Examples: Fast food (McDonalds, Burger King, Telepizza).
Automobile industry (car dealerships).
The payment scheme is usually a fixed payment plus a percentage
of sales.
It is not a case of vertical integration since the franchisee is not
the employee of the franchisor.
Franchising implies holdup problems and agency costs.
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Franchising puzzle
Franchising among gas stations that provide repair
services is more frequent that for gas stations that do
not.
Why?
2.5. Horizontal boundaries of the firm
Economies of scale
 Definition: a production process exhibits economies of
scale over a range of output if the average cost
decreases in this range of production levels.
AC(Q)
a
Average
cost function
Q*
Optimal size
of the firm
Q
2.5. Horizontal boundaries of the firm
Economies of scope
 Definition: There are economies of scope if a single firm
producing two goods X and Y has a lower average cost than
two separate firms, each producing one of the goods.
2.5. Horizontal boundaries of the firm
Sources of economies of scale and scope
 Economies of scale and scope appear because of the
existence of fixed costs that are divided into a larger
number of units as the volume of production increases.
1. Indivisibilities. (e.g. Transport).
2. Access to an efficient technology. (e.g. Machinery).
3. Stocks and uncertainty. (e.g. Seller out of stocks).
2.5. Horizontal boundaries of the firm
Sources of economies of scale and scope
4. Research and development costs (e.g.
Pharmaceutical industry)
5. Purchasing and bargaining power.
6. Publicity expenses (e.g. Sony)
2.5. Horizontal boundaries of the firm
Sources of diseconomies of scale and scope
1. Labor costs. (Empirical evidence).
2. Incentives and bureaucracy. (Coordination and
motivation costs).
3. Non-replicability of entrepreneurial talent. (Coase
1937).
4. Legal motives.
Firm boundaries
Case I: EDS – Continental Airlines
 Description of the case: managing synergies.
- System One is a firm controlled by Continental Airlines
that operates the system of electronic reservations and
other information.
- System One deals with 20% of the total reservations of US
Airline Companies.
- Until 1991, System One is also a data provider to 170
airline companies.
-
a) Why airline companies do not operate their own
reservation service?
Firm boundaries
Case I: EDS – Continental Airlines
 In 1991, the firm Electronic Data Service takes the control
of System One.
- Electronic Data Service is a leading provider of
information services in the banking and energy sectors.
-
b) Do you think taking the control of System One is
profitable operation for Electronic Data Service? Why?
Firm boundaries
Case II: Rolm - IBM
 Description of the case: managing incentives.
- Rolm is a small firm in the Sillicon Valley with rapid
growth in the computer sector (computers, information
systems.).
- Rolm has a very peculiar corporate culture: “no dressing
codes no time schedules”. However, employees work a
lot.
- To maintain the corporate culture: a large number of small
divisions and employees in Rolms’ stocks.
- Rolm compete with giants like AT&T y Northern
Telecom.
Firm boundaries
Case II: Rolm - IBM
 The management of Rolm decides to ask for the support of
IBM by giving IBM the possibility to take the control of
Rolm with the restriction of not modifying the
management style of Rolm.
Do you think taking the control of Rolm is a good decision
for IBM?
Firm boundaries
Case II: Rolm - IBM
 Do you think taking the control of Rolm is a good decision
for IBM?
- Problem: conflicting sales strategies between the two
firms. Price differentiation impossible for IBM. Less
flexibility for Rolm’s employees implying lower
commissions. Many salespersons decided to leave the
integrated firm.
- System of incentives such that Rolm’s paid with IBM
stocks.
- In 1986 most executives left the firm.
- In 1988 IBM sold Rolm.
Firm boundaries
Case III: General Motors - EDS
 Description of the case: profit sharing.
- In 1984, General Motors takes the control of Electronic
Data Service (EDS), a firm of information services.
- The success of EDS depends crucially on the motivation of
its salespersons paid bonuses in stock options.
- General Motors wants to acquire EDS to improve its
information services and then its production technology.
What do you think about the decision of General Motors?
Firm boundaries
Case III: General Motors - EDS
-
-
GM commits to maintain the management style of EDS
paying employees of EDS with stock options of EDS that
GM decided to maintain as a special class of actions of
GM.
In 1985, EDS profits increased by 400%.
What is the potential problem?
Firm boundaries
Mergers or myths
- A study by the University of Ohio State assesses the
failure of mergers to 60%.
How should we measure the success of a merger?