1. The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration Sanford J. Grossman Oliver D. Hart A Paper Summary By Amit Darekar Journal of Political Economy. August 1986, Vol. 94 Issue 4

2. 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

3. 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

4. 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

5. Application – Insurance Industry (I) THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL & LATERAL INTEGRATION 5 Insurance Industry Direct Writers Company EmployeesAgents Non-direct Writers Company Agents & Brokers May own Office equipment & building Owns the list of policyholders

6. Application – Insurance Industry (II) Applying framework to analyze the determinants of who owns the list of policy- holders ◦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

7. 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. THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL & LATERAL INTEGRATION 7 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.

8. Application – Insurance Industry (III) THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL & LATERAL INTEGRATION 8

9. 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 non- integration is desirable when both investment decisions are "somewhat" important THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL & LATERAL INTEGRATION 9

10. 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

11. APPENDIX (MODEL) Model (I) THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL & LATERAL INTEGRATION 11 Benefit of firm i’s manager at date “1”, net of investment costs 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” Ø i is some function of q1 and q2 and is increasing B i [ a i, Ø i (q 1, q 2 ) ]

12. Model (II) Summary of the assumptions: ◦None of the variables a i, q i, and B i 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 q i. 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

13. Analysis of Optimal Contract An optimal contract must maximize the total ex ante net benefits or surplus of the two managers Definition: Let a 1 *, a 2 *, q 1 *, and q 2 * be the assumed unique maximizers of (B1 + B2) subject to a i ϵ A i, q i ϵ Q i (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 B 1 [a 1, Ø 1 (q 1, q 2 ) ] + B 2 [a 2, Ø 2 (q 1, q 2 ) ]

14. Case 1: Non-integration (I) In this case manager #1 has the right to choose q 1 and manager #2 has the right to choose q 2 at date 1 At date 1, a 1 and a 2 are predetermined If no further negotiation takes place, q 1 and q 2 will be chosen simultaneously and non- cooperatively by managers 1 and 2 to maximize Ø 1 (q 1, q 2 ) and Ø 2 (q 1, q 2 ) respectively We assume, there exists a pair q ̂̂ 1, q ̂̂ 2 satisfying q 1 = q ̂̂ 1 maximizes Ø 1 (q 1, q ̂̂ 2 ) subject to q 1 ϵ Q 1 and q 2 = q ̂̂ 2 maximizes Ø 2 (q ̂̂ 1, q 2 ) subject to q 2 ϵ Q 2 In other words the game in which each manager i maximizes Ø i has a unique Nash equilibrium Therefore, the two firms can gain from writing a new contract at date “1” that specifies q 1 = q 1 (a 1, a 2 ) and q 2 = q 2 (a 1, a 2 ), 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 re- negotiation THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL & LATERAL INTEGRATION 14

15. 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

16. 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 non- cooperative 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

17. Case 2: Firm #1 Control In this case, Firm#1 owns Firm#2, and hence manager has the right to choose q 1 and q 2 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 ̂̂ 1, q ̂̂ 2 ) with (q ̄ 1, 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 ̂̂ 1, q ̂̂ 2 ) with (q ̄ 1, q ̄ 2 ) Firm #1 control will generally lead to inefficient ex ante investments since (q ̄ 1, q ̄ 2 ) ≠ [q 2 (a), q 2 (a 1 )] THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL & LATERAL INTEGRATION 17

18. Case 3: Firm #2 Control In this case, Firm#1 owns Firm#2, and hence manager has the right to choose q 1 and q 2 at date 1 We assume This case is the same as the previous one with (q 1, q 2 ) 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

19. Optimal Solution (I) If one of the pairs (q ̂̂ 1, q ̂̂ 2 ), (q ̄ 1, q ̄ 2 ), (q 1, q 2 ) happens to be very close to [q 1 (a), q 2 (a)], there will be little inefficiency in the a's and the corresponding ownership structure will achieve approximately the first-best. Proposition ◦A – If Ø i depends primarily on q i – Then non-integration yields approximately first best ◦B – If Ø 2 hardly depends on q1 and q2 – Then Firm #1 control yields first best ◦C – If Ø 1 hardly depends on q1 and q2 – Then Firm #2 control yields first best Thus, if the non-contractibles q l (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

20. Optimal Solution (II) THE COSTS AND BENEFITS OF OWNERSHIP: A THEORY OF VERTICAL & LATERAL INTEGRATION 20