VERTICAL INTEGRATION,
APPROPRIABLE RENTS,
AND THE COMPETITIVE
CONTRACTING PROCESS
B. Klein,
R. Crawford,
& A. Alchian –
1978, JLE
PAPER OVERVIEW
 A Key Question: Given the theories presented in
Coase (1937), what possibilities for post -contractual
opportunistic behavior exist and how can they be
dealt with?
 What is “Opportunistic Behavior”?
 “Unanticipated non-fulfillment of a contract or agreement”
 When some party A reneges in some form on some agreement with
some party B
OPPORTUNISM AND RENTS
 Opportunism occurs in the form of appropriation of
quasi-rents
 Specifically, after an investment is made, the presence of
appropriable quasi-rents leads to the risk of opportunism
 What are “Quasi-rents”?
 “The value of an asset above the next best use”
 What are “Appropriable Quasi-rents” (AQR)?
 “The portion of quasi-rents in excess of an assets value to the
next highest-valuing user”
EXAMPLES OF QUASI-RENTS




Party
Party
Party
Party
B
C
A
A
pays Party A $5,500 to use some equipment
will pay Party A $3,500 to use the same equipment
incurs $1 ,500 maintenance cost for the equipment
could “salvage” the equipment for $1 ,000
 Quasi-rents = Revenue – Maintenance – Salvage
= $5,500 - $1 ,500 - $1 ,000 = $3,000
 AQR
= Rate of Party B – Rate of Party C
= $5,500 - $3,500 = $2,000
DEALING WITH OPPORTUNISM
 Vertical Integration
 Examples – Paper company owns forest, paper mill, and retail
stores
 Newspaper publisher typically own their printing press, but book
publishers do not; WHY?
 Economically Enforceable Long-term Contracts
 Explicitly enforceable by an outside institution (i.e. government)
 Solutions can by prohibitively costly
 Implicitly enforced by market mechanisms (i.e., higher future
rates)
 Effective under specific situations
 Self-enforcing agreements
1. AUTOMOBILE MANUFACTURING
1919 – GM and Fisher Body entered into 10 year contractual agreement for
the supply of closed auto bodies (GM agreed to buy all bodies from Fisher)
Price of bodies were set at “17.6% + production cost” and price charged
could not exceed what Fisher charges other manufacturers nor greater than
the average market price of similar bodies produced by others.
1924 – 65% of GM’s automobiles were of closed body type (all of which
came from Fisher Body) GM very unhappy. Fisher also refuses to relocate its
plant near the GM assembly plant (mobility cost too high).
1926 – Vertical merger between Fisher Body and GM.
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2. PETROLEUM INDUSTRY
A’s OIL WELL
B’s OIL WELL
Installed oil producing equipment of A and
B + Refinery installation of D and E are
specialized to C’s pipe line (very high asset
specificity).
The portion of their value above the value to
the next best user becomes appropriable
quasi rent.
Pipeline owner C could potentially….
D’s REFINERY
E’s REFINERY
a. Purchase oil at marginal cost of
extracting oil
b. Sell the oil to the refineries to the price
of alternative sources of supply to
refineries
(e.g., train)
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2. PETROLEUM INDUSTRY
B’s OIL WELL
A’s OIL WELL
Therefore..
A, B, D and E forms a jointly owned
company which “owns” the pipeline.
JOINTLY OWNED
D’s REFINERY
E’s REFINERY
e.g., Rockefeller obtained price reduction
from railroad companies (that ship oil) by
threatening to build a pipeline. He
appropriated quasi rents from the railroad
companies.
INTEGRATION OR CONTRACT?
 All other things equal, the lower the appropriable
specialized quasi-rents, the more likely the
transaction parties will rely on contractual
relationships rather than common ownership
 If an asset offers a substantial portion of quasi -rent,
which is strongly dependent upon some other
particular asset, both assets will tend to be owned by
one party.
FINAL THOUGHTS
 What kind of assets have quasi -rents?
 Almost anything – physical assets, human capital, social constructs,
etc.
 Kessler and Stern (1959) argue that long -term contracts are a
form of vertical integration
 What continuum exists here?
 What major thresholds occur between integration and contracting?
 The issues surrounding ownership relationships and ef ficiency
quickly become complex and dif ficult to predict