Chapter 2 Firms and Markets School of Economics and Business Administration Universidad de Navarra.

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)

 Assumption A (Perfect Competition  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? 2.1.1. Efficiency and limits of the market

 Imperfect Competition  Increasing Returns to Scale  Externalities  Public Goods  Asymmetry of Information  Search Costs 2.1.2. Market failures

 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(q 1 ) = cq 1, 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) Distributor (Monopolist 2) Consumers Cost function: cq 1 Transformation cost: 0 r p Demand: p=1-q 2.1.2. Market failures Imperfect Competition q1q1q1q1 q2q2q2q2

Consumers Monopoly relationship r p 2.1.2. Market failures Imperfect competition Monopoly relationship

Consumers p 2.1.2. Market failures Imperfect competition Monopoly relationship Vertical integration - Cooperation and negotiation implement a better solution than competition. Internal bargaining

 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 pq 2 -C(q 2 ) ≡ Max (1-q 2 -r)q 2 Where q is the quantity of the product sold to the market. CPO:q 2 = (1-r)/2 r=1-2q 2 2.1.2. Market failures Imperfect Competition

 Then, Monopoly 1 solves the following maximization problem, where q 1 is the quantity sold by Monopoly 1 to Monopoly 2, i.e. q 1 = q 2 = 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: q I = (1-c)/2 > q* = (1-c)/4, y p I = 1 - q I = (c+1)/2 < p* = 1 – q* = (c+3)/4 so that: p*> p I π I = 1/4 × (1-c)² and π NI = 3/16 × (1-c)² 2.1.2. Market failures Imperfect Competition

  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: C s (s) = s²/2 so that MC s = 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: C f (f) = f²/2 + f×s/2 so that MC f = f + s/2 - - Per unit prices of steel and fish are p s = p f = 10. 2.1.2. Market failures Externalities

  Exercise Steel Mill and Fishery 2.1.2. Market failures Externalities Steel mill Fishery Marginal cost: s Marginal cost : f+s/2 River

  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: p s = CM s so that 10 = s p f = CM f so that 10 = f + 5 then f = 5 These production levels imply the following levels of profit: π s = 50 y π f = 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) ≡ p s × s + p f × f -[C s (s) + C f (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: π s (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 Externalities

  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. 2.1.2. Market failures Search costs

  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 Refining division P = Oil transfer price 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 Ishikawa, 1962

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.” 2.1.3. Coordination by management

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.

 Example I: the producer of aluminum.  Example II: investment in studying the lecture notes of a professor. Would you pass the exam of the same course in another university? Bauxite Aluminum Consumers 2.2.1. Asset specificity

  Different types of specificity. 1. 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. 2.Physical asset specificity. This refers to assets with physical characteristics that are designed for a specific transaction. Examples: mold, perfumes. 3. 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. 4.Specific human capital.

  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: C A (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 P V, the rent of firm A is equal to its profit.

  Example: Firm A – Volkswagen. Alternative option for firm A: P m, where P m > c. I = 8500000€, c = 3€, P m = 4€ < P V = 12€. Compute the rent and the quasi-rent associated to the specific investment of firm A. R A = 1000000 × (P V - c) – I = 500 000 € QR A = 1000000 × (P V - P m ) = 8 000 000 € If the price of the best alternative was equal to the price offered by Volkswagen (P m = P V ), then the quasi-rent would be equal to zero. 2.2.2. Quasi-rents

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).

  Example: Volkswagen. Volkswagen knows that it can offer a price between P m y P V. Then, we are in a case of bilateral bargaining where Volkswagen has the negotiation power. - For example, firm A accepts the new price P V = 10€ instead of 12€ since P V > P m. - The problem is that for P V =10€, firm A incurs losses since its rent is negative in that case: R A =(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. R P = 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? QR P = 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 €. R P = 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% 2.2.3. 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. Vertical integration as a solution to 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 2.2.4. Transaction costs and the “holdup” problem

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).

 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. Vertical integration as a solution to 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 Transaction costs and the “holdup” problem

2.3. Behavioral approach to the holdup problem  The behavioral theory of the firm is characterized by the following assumption: Assumption B 2 (Social preferences) Agents do not only care about their own material payoffs but also about others' payoffs and actions.

 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. 2.3. Behavioral approach to the holdup problem

 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 of the firm

 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 to the holdup problem

 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) 2.3. Behavioral approach 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. 2.4. Vertical and horizontal boundaries of the firm Raw materials Parts Distribution Final Assembly

 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 and horizontal boundaries of the firm Raw materials Parts Distribution Final Assembly Raw materials Parts Distribution Final Assembly

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) = T I – T NI > 0 & ΔT’(k)<0 ΔA (k) = A I – A NI & ΔA’(k)<0 2.4. Vertical boundaries of the firm Technical and agency efficiency

 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. 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).

 Definition. Vertical integration consists in the control by a single entity of several steps in the production or distribution of a product or service.  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 and horizontal boundaries of the firm

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) = T I – T NI > 0 & ΔT’(k)<0 ΔA (k) = A I – A NI & ΔA’(k)<0 2.4. Vertical boundaries of the firm Technical and agency efficiency

 Technical and agency efficiency as a function of asset specificity (k). ΔC(k)= ΔT(k) + ΔA(k) 2.4. Vertical boundaries of the firm k k*

 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. 2.4. Vertical boundaries of the firm k k*

 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. 2.4. Vertical boundaries of the firm 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 Probability of vertical de Integration Component with high engineering effort + 15% Specific component+ 82%

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.

  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. 2.4. Vertical boundaries of the firm Vertical integration and asset ownership Printer Firm 1 Publisher Firm 2 Consumers

  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). 2.4. Vertical boundaries of the firm Vertical integration and asset ownership Printer Firm 1 Publisher Firm 2

 2- Backward integration. In that case, the printer will be even less willing to invest in specific assets than in the case of non- integration 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. 2.4. Vertical boundaries of the firm Vertical integration and asset ownership Printer Firm 1 Publisher Firm 2

 2- Backward integration. In that case, the printer will be even less willing to invest in specific assets than in the case of non- integration 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. 2.4. Vertical boundaries of the firm Vertical integration and asset ownership Publisher Firm 2 Printer Firm 1

 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 Vertical integration and asset ownership

 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? 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. Alternatives to vertical integration 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. Alternatives to 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. Alternatives to vertical integration 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? Alternatives to vertical integration 2.4. Vertical boundaries of the firm Alternatives to vertical integration

 Definition: a production process exhibits economies of scale over a range of output if the average cost decreases in this range of production levels. Economies of scale 2.5. Horizontal boundaries of the firm Economies of scale

 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. Economies of scope 2.5. Horizontal boundaries of the firm Economies of 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). Sources of economies of scale and scope 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) Sources of economies of scale and scope 2.5. Horizontal boundaries of the firm Sources of economies 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. Sources of diseconomies of scale and scope 2.5. Horizontal boundaries of the firm Sources of diseconomies of scale and scope

 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? Case I: EDS – Continental Airlines 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? Case I: EDS – Continental Airlines Firm boundaries Case I: EDS – Continental Airlines

 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. Case II: Rolm - IBM 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? Case II: Rolm - 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. Case II: Rolm - IBM Firm boundaries Case II: Rolm - IBM

 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? Case III: General Motors - EDS 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? Case III: General Motors - EDS Firm boundaries Case III: General Motors - EDS

-A study by the University of Ohio State assesses the failure of mergers to 60%. How should we measure the success of a merger? Mergers or myths Firm boundaries Mergers or myths

Chapter 2 Firms and Markets School of Economics and Business Administration Universidad de Navarra.

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Chapter 2 Firms and Markets School of Economics and Business Administration Universidad de Navarra.

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