The Choice of Organizational Form VERTICAL FINANCIAL OWNERSHIP VERSUS OTHER METHODS OF VERTICAL INTEGRATION Mahoney, SMJ Joshua Downs 8/31/2015

Main Points Presents a generalized theory for predicting and prescribing financial ownership that integrates and extends previous work done under both the strategy and industrial organization paradigms Vertical integration strategy literature emphasizes motives to vertically integrate, but lacks prescriptive guidance in selecting from the pool of possible organizational form choices ◦Including: Hierarchy, Inside Contracting, Joint Venture, Clan, Relational Contract, Long- term Contract, and Spot Market In the absence of transactions costs, outcomes driving every motive for vertical financial ownership may be achieved alternatively by an appropriate vertical contract Transactions costs underemphasizes information asymmetries, while Agency theory ignores asset specificity ◦Both theories simultaneously considered (Task Programmability, Nonseparability, & Asset Specificity) can help explain and predict the appropriate organizational form

Why Vertically Integrate? Strategic considerations ◦Price Squeezing (Increasing input costs, lowering output costs), Barriers to Entry, overcome regulatory limits to rate of return regulation, maintain stability of strategic groups (Industry advantage?) Output and/or input price advantages ◦VI minimizes risk of rent appropriation from monopolistic upstream firms ◦Addresses risk of arbitrage between sets of downstream firms with heterogeneous price sensitivities when price discrimination is practiced Uncertainty ◦Asymmetric information between upstream and downstream stage participants, risk of supply failure or overproduction respectively ◦Integration improves forecasting for pricing and capital investment ◦Discrepancy between VI and risk/uncertainty reduction claims (Williamson and Harrigan) ◦Reconciled by discussion of dynamic or static levels of asset specificity ◦Measurement and quality uncertainty: key inputs and point of sale service ◦Complexity requires more specialized distribution and sales (Bucheli et al., 2010) ◦Technological uncertainty leads to more vertical integration unless reduced asset specificity (flexibility) occurs

Which Organizational Form Should be Used? Financial Ownership Outcomes can be achieved through Contracting ◦Strategic Advantages ◦BTE, ROR regulation avoidance through transfer pricing, oligopolistic pricing arrangements for strategic group stability ◦Input/Output Price Discrepancies ◦Profit influencing downstream decisions can be controlled through other means than financial ownership ◦Franchise fees, resale price maintenance, tying uncontrolled substitute inputs with controlled product ◦Tying arrangements, territorial restrictions facilitate price discrimination ◦Uncertainty ◦Asymmetric upstream information ◦Auxiliary markets can provide info ◦Supply concerns ◦Contractual provisions like hostages ◦Quality ◦Territories and price maintenance reduce price competition inducing downstream competition on quality ◦Vertical price fixing arrangements ◦Technology ◦Licensing can sufficiently minimize difficulties inherent in tech transfer These motives for vertical integration cannot per se determine the organizational form between vertical contracting and financial ownership.

What Determines Organizational Form? Transaction costs concerning attributes of the transaction ◦Ex ante costs: Search and information, Drafting, bargaining, and decision, Agreement safeguarding ◦Ex post costs: Monitoring and Enforcement, Adaptation and haggling, Bonding, Maladaptation Agency costs concerning incentives and measurement problems of the individual ◦Monitoring by principal, bonding expenditures by agent, loss of residuals 2 Branches ◦Mathematical Principal Agent Models ◦Unboundedly Rational, Firm as nexus of contracts, Alignment of ex ante incentives sufficient to achieve vertical financial ownership outcomes through contracting ◦Positive Agency Theory ◦Emphasizes information asymmetry issues, reward based on output or behavior ◦Nonseparability of effort to output ◦Low task programmability reduces effectiveness of monitoring Measurement costs and transaction costs should be considered simultaneously for the purpose of predicting organizational form ◦Emphasis on Measurement problems fills Transaction Costs Gap (571)

Why Use Financial Ownership? Advantages of Vertical Financial Ownership ◦Profit ◦Costs related to preemptive claims on profit by separate firms eliminated ◦Coordination and Control ◦Authority derived inducements to reduce opportunistic behavior ◦Resolution of conflict more efficiently achieved internally than through 3 rd party (litigation) ◦Audit and Resource Allocation ◦Internal divisions can be audited, superior information on which to base allocations so as to eliminate opportunistic behavior ◦Motivation ◦Inculcation of solidarity (organizational identity) converges interests to reduce behavioral uncertainty ◦Communication: Internally coded communication more efficient than external communication ◦Even frequent interactions feature opportunism concerns

Why Not Use Financial Ownership? Disadvantages of Vertical Financial Ownership ◦Bureaucratic Costs ◦Difficult to anticipate, synergies overestimated ◦Additional tasks may require additional skills ◦Increasing superior/subordinate spans obviates communication advantages ◦Lack of market incentives leads to increased slack, norms of reciprocity form ◦Strategic Costs ◦Reduced access to knowledge of from severing ties to outside partners ◦Specialized assets (Indivisible?) leading to excess capacity ◦Reduced flexibility, increased exit barriers, psychological commitments and divestment related administrative difficulties ◦Flexibility/Stability tradeoffs ◦Production Costs ◦Internal Inputs must be sufficiently utilized to achieve sufficient scale compared to market sourced inputs of competitors ◦Capital Drain concerns for small firms (Williamson, 1975) ◦Capacity imbalances (among stages of production?)

What Should Organizational Form Decision be Based Upon? Framework for Predicting Organizational Form ◦Transactions dimensionalized according to frequency, uncertainty, and asset specificity ◦Uncertainty (Demand and technological) and asset specificity (Human, Physical, Site) ◦Frequency only influences structure choice in intermediate asset specificity, not considered ◦Agency perspective emphasizes information asymmetry issues ◦Nonseparability ◦Task Programmability ◦Integration of theories ◦Task programmability, nonseparability, demand uncertainty, technological uncertainty, and asset specificity are five determinants of organizational form ◦Demand and technological uncertainty are theoretically indeterminate, thus model focuses on interactions of remaining 3 dichotomous variables as determinants of organizational form

Discussion How might you go about testing this theoretical framework empirically? What are some empirical examples of industries/firms where, applying the framework discussed in the paper, an appropriate organizational form might be apparent? What are some variables that might confound practical managerial efforts to utilize the prescribed organizational form?