The Costs and Benefits of Ownership:
A Theory of Vertical and Lateral
Integration
Sanford J. Grossman
Oliver D. Hart
Journal of Political Economy.
August 1986, Vol. 94 Issue 4
A Paper Summary
By
Amit Darekar
Introduction
This paper builds on the foundations Coase (1937), Klein, Crawford, and Alchian
(1978), and Williamson (1979), which emphasizes the benefits of “control” in
response to situations where writing or enforcing a complete contract is difficult
We define a firm as being composed of the assets that it owns
Ownership is the purchase of residual rights of control
There can be harmful effects associated with wrong allocations of residual rights
We develop a theory of integration
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
2
Integration : Transaction Cost based arguments
The transactions will be arranged in the firm when the cost of doing this is
lower than the cost of using market – Coase (1937)
A contractual relationship between a separately owned buyer and seller will
be plagued by opportunistic and inefficient behavior in situations in which
there are large amounts of surplus to be divided ex post and in which the
ex ante contract does not specify a clear division of this surplus – Klein,
et al.(1978) and Williamson (1979)
This argument however does not explain:
1.
How the scope for such behavior changes when one of the self interested
owners becomes an employee of the other owner?
2.
How can integration ever be strictly worse than non-integration – that is
what limits the size of the firm?
3.
What does it mean for one firm to be more integrated than the other?
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
3
Assumptions
We define a “Firm” to consist of assets that it owns or over which it has
control; ownership is the power to exercise the control
We assume that:
◦ There is no difference between employees and outside contractors where firm
provides all the tools and other assets to be used by contractor
◦ A payment method is some function of the observable states of nature and the
observable performance of the parties to the contract
◦ Integration in itself does not make any new variable observable to both parties
◦ Integration in itself does not change the cost of writing down a particular
contractual provision
◦ The relationship between the firms is assumed to last 2 periods
◦ No aspects of production decisions are ex-ante contractible
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
4
Application – Insurance Industry (I)
Insurance
Industry
Owns the list of
policyholders
Direct Writers
Company
Employees
Agents
Non-direct
Writers
Company
Owns the list
of
policyholders
Agents &
Brokers
May own Office
equipment &
building
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
5
Application – Insurance Industry (II)
Applying framework to analyze the determinants of who owns the list of policyholders
◦ There is only one asset, i.e. the list of policyholders. The choice is between Firm #1 control
and Firm #2 control
◦ We assume that
◦ The agent devotes effort that is not verifiable to acquiring and keeping clients.
◦ The agent can either "work" and produce only persistent clients or "not work" and produce only
temporary clients
◦ If effort were verifiable, the insurance company would be prepared to compensate the agent for
the extra effort of delivering persistent clients.
◦ Implication of these assumptions is that if the agent is paid a commission for the initial
acquisition o the client and no later commission as a function of the persistence of the
client, then the agent will deliver only temporary clients, and this is inefficient relative to
the first-best
◦ In order to induce the agent to produce persistent clients, the renewal premium must
have some component of a reward to agent for the effort of delivering persistent clients –
this is called as back-loading structure
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
6
Application – Insurance Industry (III)
◦ This back loading of commissions has no implications on “who owns the list”,
unless there are non-contractibles, such as
1. Non-contractibles that can hurt the agent if the company owns the list
2. Non-contractibles that can hurt the company if the agent owns the list
◦ Trade-off
◦ If the company owns the list, the agent will have an insufficient incentive to deliver
persistent clients; that is, he will underinvest in this activity.
◦ If the agent owns the list, the company will underinvest in list building, but the
agent will work hard to deliver persistent clients.
Our analysis therefore predicts that, in products in which the renewal is not guaranteed and is
sensitive to the agent's actions, the agent will be more likely to own the list, whereas in products in
which the renewal is more certain and is less sensitive to the agent's actions, the company will be
more likely to own the list.
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
7
Application – Insurance Industry (III)
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
8
Conclusions (I)
1.
We have argued that there is often a low-cost alternative to contracts
that allocate all specific rights of control.
2.
Ownership is the purchase of the residual rights of control. Vertical
integration is the purchase of the assets of a supplier (or of a purchaser)
for the purpose of acquiring the residual rights of control
3.
We argue that the relevant comparison is between a contract that
allocates residual rights to one party and a contract that allocates them
to another.
4.
Integration shifts the incentives for opportunistic and distortionary
behavior, but it does not remove these incentives.
5.
Integration is optimal when one firm's investment decision is
particularly important relative to the other firm's, whereas nonintegration is desirable when both investment decisions are
"somewhat" important
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
9
Conclusions (II)
6.
Contractual incompleteness can lead to other distortions - residual
rights may matter if the ex post distribution of the surplus is
important for other reasons
7.
If there is some barrier to ex post renegotiation, control of residual
rights will be important in affecting the size of the ex post surplus as
well as its distribution
8.
Though we have emphasized residual rights of control over assets in
order to explain who owns which assets, we can also use our theory
to explain residual rights over actions
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
10
APPENDIX (MODEL)
Model (I)
Benefit of firm i’s manager at date “1”, net of
investment costs
Bi [ ai , Øi (q1, q2) ]
Let,
#1, #2: Firm 1 and Firm 2 engaged in relationship
The firms sign a contract on date “0”
a1, a2: Relationship-specific investments made by each manager after signing
contract
q1, q2: Production decisions made by respective managers at date “1”
Øi is some function of q1 and q2 and is increasing
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
11
Model (II)
Summary of the assumptions:
◦ None of the variables ai, qi, and Bi is ex ante contractible. Hence, all the
date “0” contract allocate ownership rights/residual rights of control to
the two managers
◦ After the contract is signed, a1 and a2 are chosen simultaneously and
non-cooperatively by managers 1 and 2
◦ At date “1”, the owner of the firm I has the right and power to choose qi.
If there is no further negotiation, the choices of different owners are
made simultaneously and non-cooperatively.
◦ There is a competitive market in identical potential trading partners at
date “0”, which determines the ex ante division of the surplus between
the two managers. Given this ex ante division, an optimal contract simply
maximizes one manager's benefit subject to the other manager's
receiving his reservation utility
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
12
Analysis of Optimal Contract
An optimal contract must maximize the total ex ante net benefits or surplus
of the two managers
B1 [a1 , Ø1 (q1, q2) ] + B2 [a2 , Ø2 (q1, q2) ]
Definition: Let a1*, a2*, q1*, and q2* be the assumed unique maximizers of
(B1 + B2) subject to
ai ϵ Ai , qi ϵ Qi (i = 1,2)
There will be three cases to consider:
◦ Case 1: The firms remain non-integrated
◦ Case 2: Firm #1 owns Firm #2
◦ Case 3: Firm #2 owns Firm #1
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
13
Case 1: Non-integration (I)
In this case manager #1 has the right to choose q1 and manager #2 has the right to choose q2
at date 1
At date 1, a1 and a2 are predetermined
If no further negotiation takes place, q1 and q2 will be chosen simultaneously and noncooperatively by managers 1 and 2 to maximize Ø1 (q1, q2) and Ø2 (q1, q2) respectively
We assume, there exists a pair q ̂1, q ̂2 satisfying q1 = q ̂1 maximizes Ø1 (q1, q ̂2 ) subject to q1 ϵ
Q1 and q2 = q ̂2 maximizes Ø2 (q ̂1, q2 ) subject to q2 ϵ Q2
In other words the game in which each manager i maximizes Øi has a unique Nash equilibrium
Therefore, the two firms can gain from writing a new contract at date “1” that specifies q1 =
q1 (a1, a2) and q2 = q2 (a1, a2), where these are the maximizers of the Optimality function
The new contract will specify a transfer price “p” that serves to allocate the gains from renegotiation
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
14
Case 1: Non-integration (II)
We assume that the parties split the increase in total surplus 50:50; that is the
transfer price “p” satisfies
This is in fact the Nash Bargaining Solution.
We assume that a1 and a2 are chosen non-cooperatively by the agents at date “0”.
A Nashi equilibrium in date “0” investments is a pair
such that
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
15
Case 1: Non-integration (III)
The total ex ante surplus from the relationship in this equilibrium is then
The first-order conditions for a Nash equilibrium are
Using the envelope theorem to eliminate remaining terms involving the ex post
efficient q(a)
The inefficiency arises, then, because manager i puts 50 % weight on the noncooperative outcome q̂ , instead of all the weight on the cooperative outcome
In this model all the inefficiency is due to the wrong choice of ex ante
investment levels.
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
16
Case 2: Firm #1 Control
In this case, Firm#1 owns Firm#2, and hence manager has the right to choose q1 and
q2 at date 1
We assume
We will continue to assume that the parties split the gains from renegotiation 50:50
Given the 50 percent sharing rule, manager z's final payoff is as in earlier Nash
Bargaining solution replacing (q 1̂ , q 2̂ ) with (q 1̄ , q ̄2)
The date 0 Nash equilibrium in investments and the final level of surplus are also
defined as in the case of non-integration, again replacing (q 1̂ , q 2̂ ) with (q ̄1, q 2̄ )
Firm #1 control will generally lead to inefficient ex ante investments since (q 1̄ , q 2̄ ) ≠
[q2(a), q2(a1)]
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
17
Case 3: Firm #2 Control
In this case, Firm#1 owns Firm#2, and hence manager has the right to choose
q1 and q2 at date 1
We assume
This case is the same as the previous one with (q1, q2) replacing (q ̄1, q ̄2)
everywhere. Again ex ante investments will generally be inefficient
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
18
Optimal Solution (I)
If one of the pairs (q ̂1, q ̂2), (q ̄1, q ̄2), (q1, q2) happens to be very close to [q1(a), q2(a)], there
will be little inefficiency in the a's and the corresponding ownership structure will achieve
approximately the first-best.
Proposition
◦ A – If Øi depends primarily on qi – Then non-integration yields approximately first best
◦ B – If Ø2 hardly depends on q1 and q2 – Then Firm #1 control yields first best
◦ C – If Ø1 hardly depends on q1 and q2 – Then Firm #2 control yields first best
Thus, if the non-contractibles ql (l = 1 or 2) have a small effect on firm j's benefit Bj, it is efficient for firm i
to control them.
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
19
Optimal Solution (II)
THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL &
LATERAL INTEGRATION
20