Vertical Integration, Appropriable Rents, and the Competitive Contracting Process BA549 Session 2: Transaction Cost Economics - Theory Benjamin Klein Robert G. Crawford Armen A. Alchian Journal of Law and Economics (1978) by Eunkwang Seo, updated by Nate

Agenda Research Question: Q. Why is vertical integration chosen over market contracts for economic transactions? Theory higher asset specificity avoidance of post- contractual opportunism vertical integration more appropriable quasi rents created

What Are Transaction Costs? Two Types of Transaction Costs Ex-ante Transaction Costs : Searching and information costs, negotiation, and bargaining costs… Ex-post Transaction Costs : Monitoring costs, enforcement costs, dispute-settling costs …. The primary purpose of this article is to show how the mechanism that post-contractual opportunistic behavior can lead to the vertical integration of economic transactions.

Asset Specificity and Vertical Integration Monopoly Rents vs. Quasi Rents The economic quasi-rent value of the asset is defined as the excess of its value over its value of its next best use to another user. The presence of appropriable quasi rents generated by asset specificity is the primary determinant to vertical integration. That is, vertical integration is a means of economizing on the costs of avoiding risks of appropriation of quasi rents in specialized assets by opportunistic individuals. Monopoly Rents Quasi Rents Abnormal returns caused by limited market entry Abnormal returns caused by specialized assets

Post-contractual Opportunism Characteristics Incomplete contracts Relative post-contractual bargaining power (e.g. , the press owner can impose large costs on the publisher by alleging breakdowns and high maintenance cost) Non-fulfillment of contracts Loss of Efficiency Further Questions Are there alternative solutions besides vertical integration? If yes, when should we choose the alternative solutions vis-à-vis vertical integration?

Alternative Solutions and Comparative Assessments Long-term Contracts Explicit Long-term Contracts An explicitly stated contractual guarantee legally protected by government or some other outside institution. Implicit Long-term Contracts An implicit contractual guarantee enforced by the market mechanism of withdrawing future business if opportunistic behavior occurs. Comparative Assessments Explicit long-term contracts: High litigation costs Implicit long-term contracts: Direct cost imposition on the opportunistic party Reputation cost on opportunistic behaviors Premium stream The cost of using long-term contracts increases proportionally to appropriable quasi rents and asset specificity.

Examples GM and Fisher Body Investment in Specialized Assets In 1919, GM signed a ten-year contract with Fisher Body for the supply of closed metal bodies. Contractual Devices To encourage the firm-specific investment, GM provided an exclusive dealing clause to Fisher Body on a cost plus 17.6% basis. Unexpected Changes in Market Early1920s, demand for closed metal bodies drastically increased, and thus the cost plus 17.6% becomes too high to GM. Opportunistic Behavior of Fisher Body Fisher Body refused to adjust the price and to move closer to GM. Vertical Integration In 1926, GM acquired the remaining stock in Fisher Body.

Examples Petroleum Industry Specialized Assets: oil refineries and oil-producing properties are specialized to oil pipelines Potential Opportunistic Behaviors High Entry Barrier  Market Power of Pipeline Owner At the Gathering End: pipeline owners buy all crude oil at low cost. At the Delivery-to-Refinery End: sell it to refineries at a much higher price. Remedying Mechanism Forming a joint ownership of the pipeline between oil producers and refineries corresponding to the relative share of oil used. Other inputs such as oil tankers and assets used for refinery have low asset specificity  Joint ownerships are not preferred.

Examples Specific Human Capital (Intangible Asset) Slavery is prohibited by law  Long-term contracts (explicit/implicit) > Vertical integration The opportunistic behavior of labor union Extracting both monopoly rents by excluding other alternative labors and the short-run appropriable quasi rents by taking advantage of asset specificity (e.g. perishable products)  Acknowledging the possibility, farmers will under-invest in specific assets  loss of efficiency Implicit Contract Solution: Reputation Costs > Short-run Opportunistic Gains The opportunistic behavior of the firm Investing in specific human capital Long-term contract solution: Union creating long-term employment relationship  defend against both firm opportunism (e.g., by strike threat) and employee opportunism (e.g., by withholding pension rights)

Examples Leasing Inputs and Ownership of the Firm Transportation capital Low Specificity: planes, trucks, or cars used by a firm High Specificity: Rail companies own steam locomotives and lands; Meat packers own specialized refrigerator cars. Land contract Monitoring and Specifying relevant contract terms are cheap. Land owners cannot easily behave opportunistically during litigation process Therefore, although with high specificity and large sunk costs, long-term contracts are preferred. Brand-name capital Highly specialized to the specific “name” Franchising (rental contract but much closer to vertical integration)

Examples Social Institutions – e.g., country clubs Specialized capital: Friendship among each other The club is mutually owned by members, but not the golf courses (with low specialized capital involved, i.e. friendship) Owner Opportunism Raising membership fees for continuing membership or selling to other undesirable people outside the club Member Opportunism If each person owns a share of the corporation (i.e. the club), then he could threaten to sell his share to undesirable outsiders, extracting payments for not selling.

Conclusion and Discussion Hybrid Control Mechanism Most business relationships are not taking one of the extreme organizational forms (i.e., market contracts or vertical integration). Many long-term contractual relationships (e.g., franchising) blur the line between the market and the firm. Thus, the pertinent economic question will be “What kinds of contracts are used for what kinds of activities, and why?” (Specialized Assets  Specialized Activities  Specialized Questions  Specialized Organizational Forms) Discussion Question: Is high asset specificity always associated with high sunk cost, and therefore a higher possibility of opportunism?