1. The Choice of Organizational Form: Vertical Financial Ownership versus Other Methods of Vertical Integration (Joe Mahoney, SMJ 1992)
I-Chen Wang

2. Distinction between Concepts
Vertical Financial Ownership (VFO henceforth)
Elimination of contractual or market exchanges + substitution of internal transfers within the boundaries of the firm
Vertical Contracting (VC henceforth)
A variety of contractual relationship, e.g. resale price maintenance, exclusive dealing, franchising, etc.
VFO
Mkt.
Intermediate forms of VC
Vertical Integration

3. Vertical integration strategy
In the absence of agency theory and transaction costs, vertical financial ownership and vertical contracting are equivalent governance structures for achieving corporate objectives.
Research question: When market mechanisms are sufficient, when intermediate forms of vertical contracting become necessary, and when vertical financial ownership becomes the preferred governance structure

4. To Overcome Market Failures
Market failures call for “institutions of capitalism”
Causes of market failures:
Opportunism
Environment uncertainty/complexity + bounded rationality
Asymmetric information
Small numbers bargaining situation asset specificity

5. Vertical integration Strategic considerations
Eliminate competition, e.g., oil refiner
Output and/or input price discrepancies
Eliminate monopoly power from each production stage, minimizing risk of appropriation
Uncertain costs and prices
Holding asset specificity constant, VI increase with uncertainty (TCE); but, increase in uncertainty leads to less specialized assets (Harrigan)
Output measurability, shirking

6. ADVANTAGES OF VFO Transaction costs theory suggests the following:
Profit – eliminate preemptive claims on profits between separate firms
Coordination and Control – better control of opportunistic behavior due to authority relationships; disputes handled more effectively
Audit and Resource Allocation – ability to audit whole firm; ability to control all resources
Motivation – solidarity and clan-like emotions
Communication – improved coding system

7. The Disadvantages of VFO
Bureaucratic costs
Implementation costs
Loss of high-powered market incentives
High internal costs
Strategic costs
Loss of access to info. and tacit knowledge
Increasing sunk cost and/or chronic excess capacity
Over psychological commitment
Production costs
Cost disadvantages without minimum efficient scale
Capital drain
Capacity imbalance
----VFO is not sufficient to meet those considerations!

8. To Integrate VFO, VC and TCs
Dimensions of transaction costs
Frequency: occasional or recurrent transactions
Uncertainty: demand and technological
Asset specificity: human, physical and/or site firm-specific investments
Dimensions of agency costs
Non-separability problems: asymmetry info. b/w output and effort
Task programmability: knowledge of the transformation process

9. Proposition
Non-separability, programmability (agency theory Information asymmetry), specificity (TCE) are three factors to suggest the vertical ownership decision
Low task programmability
High task programmability
Low specificity
High specificity
Low non-separability
Spot market
Long-term contract
Joint venture
High non-separability
Relationship contract
Clan (hierarchy)
Inside contract
Hierarchy

10. Contributions and Implications
Theoretical contributions
Propose a general theory of vertical integration strategy
Fill in the research gap by incorporating the vertical governance structure comparison
Integrate the agency and transaction costs theory
Empirical implications
Empirical study on the three variables are warranted
Whether the dimensions of TCs specified here are “sufficient statistics” for predicting organization form
Whether the efficiency orientation alone is adequate to predict organization form