Page 1/20 The Choice of Organizational Form: Vertical Financial Ownership Versus Other Methods of Vertical Integration Joseph Mahoney, SMJ, 1992 Presented by Jenna Moore, BADM 545 Fall 2013

Page 2/20 OVERVIEW  Purpose: To provide an integrative framework for predicting and prescribing organizational form of vertical control (Table 3, p. 576)  Synthesizes empirical evidence from economics and strategy  Applies insights from agency and transaction cost theory  Structure of Paper: (1)Advantages of vertical integration: purported motives (2)Isomorphic nature of vertical financial ownership and vertical contracting (3)General theory for predicting patterns of vertical financial ownership and vertical contracting in different environments: Integrating transaction costs and agency theory

Page 3/20 Advantages of Vertical Integration Strategy  Motives allegedly explaining vertical financial ownership: (1)strategic considerations—increasing barriers of entry (‘price squeezing’), foreclosing competitors, raise competitors’ costs (2)output/input price advantages—successive monopoly, bilateral monopoly, upstream monopoly (3)Uncertainties in costs/prices—minimize risks associated with supply and demand uncertainties, measurement and quality uncertainties *Problem: motives provide explanations for vertical coordination, but do not provide prescriptions on choice of governance structure

Page 4/20 Isomorphic Nature of Vertical Integration and Contracting  Vertical contracting (e.g., resale price maintenance, exclusive dealing) = alternative to vertical financial ownership  Offers illustration of isomorphism by addressing each of the 3 preceding motives using vertical contracting instead of vertical financial ownership  Main point: In the absence of transaction costs, vertical contracting and vertical financial ownership are interchangeable

Page 5/20 Two Branches of Agency Theory 1)Mathematical principal agent models  Ignores problems of bounded rationality and transaction costs (‘Coasean world’)  The firm is viewed as a “nexus of contracts”  Organizational form is irrelevant 2) Positive agency theory  Agency costs are subset of transaction costs  Costs include: monitoring and bonding expenditures, and the residual loss

Page 6/20 Advantages of Vertical Financial Ownership According to transaction costs theory, the following advantages are generated by vertical financial ownership: (1)Preemptive claims on Profit (2)Coordination and control (3)Audit and resource allocation (4)Motivation (5)Communication Conclusion: when a firm vertically integrates, changes occur that relate to governance structures, incentives, and ownership

Page 7/20 Disadvantages of Vertical Financial Ownership But should vertical financial ownership be chosen based on governance structure, ownership, and incentive advantages?  Making this decision based solely on organizational economics is limited; lacks a comparative institutional assessment When considering implementation problems, strategic management researchers have uncovered the following disadvantages: (1)Bureaucratic costs (2)Strategic costs (3)Production costs

Page 8/20 Framework For Predicting Organizational Form Recall: transaction costs approach considers asset specificity but ignores interactive effects of measurement problems Positive agency theory considers interactive effects of measurement problems but ignores asset specificity  The integration of these two perspectives allows for predictions and prescriptions to be made regarding choice of governance structure  Essentially 8 different circumstances that might face the firm (see Table 3)

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Page 10/20 Conclusion Integrating strategy and economics allows us to gain new and interesting theoretical insights A synthesis of the agency and transaction costs literatures allowed for the creation of an integrative framework used to predict and prescribe the optimal vertical governance structure Future research should investigate empirically whether or not the relationships within this framework do in fact predict organizational form