Vertical Integration, Appropriable Rents, and the Competitive Contracting Process

1. Vertical Integration, Appropriable Rents, and the Competitive Contracting Process Journal of Law and Economics (1978) Benjamin Klein UCLA Armen A. Alchian UCLA Robert G. Crawford BYU Presented by: Danielle Jones

2. Background • Coase (1937): Transaction, coordination, and contracting costs are explicitly considered when determining the extent of vertical integration such that a firm will internalize all activities that are cheaper to conduct within the firm rather than contracting them in the market. • Williamson (1975):Due to imperfect information, all transactions are subject to costs that stem from potential or actual opportunism. • Opportunism = “self-interest seeking with guile” • Teece (1976): Regardless of the degree of specificity of provisions in a contract, there will always be room for opportunism/reneging

3. Main Idea of This Paper • Explores one particular cost of using the market:the possibility of post-contractual opportunistic behavior • Emphasizes the presence of appropriable specialized quasi rents as the motivation for contract reneging and opportunistic behavior General Theory: • As assets become more specific, more appropriable quasi rents are created, and the costs of contracting will increase relative to the costs of vertical integration • Therefore….ceteris paribus, as appropriable specialized quasi rents increase, we are more likely to see vertical integration

4. What are Quasi-Rents? • Quasi-rent = the value of an asset’s next best use to another renter; excess of asset value over salvage value QR = AV - SV • Appropriable quasi-rent = portion of quasi-rent (if any) in excess of its value to the 2nd highest-valuing user AQR = QR - NHV

5. Quasi-Rent Example • Party A = printing press owner • $1,000 salvage value; $1,500 operating costs • Party B = publisher B • Pays $5,500 for printing services • Party C = publisher C • Will offer $3,500 for printing services • Quasi-Rent = Revenue – operating costs – salvage value = $5,500 - $1,500 - $1,000 = $3,000 • Appropriable Quasi-Rent = Quasi-rent – next best quasi-rent = $3,000 - ($3,500 - $1,500 - $,1000) = $2,000

6. Mitigating Opportunistic Behavior If appropriable quasi-rents of an asset lead to opportunism, how can opportunistic behavior be mitigated? • Vertical integration (ownership) • Costs exist, but they are not related to the extent of appropriable specialized quasi-rents • Economically enforceable long-term contract • Costs are positively related to extent of appropriable specialized quasi-rents • Explicit enforcement = Legally enforced by the gov’t or some other third party institution • Very costly to write, monitor, enforce, and litigate • Implicit enforcement = Enforced by the market mechanism of withdrawing future business if opportunistic behavior occurs (goodwill market enforcement mechanism) • Commonly implemented by offering potential “cheater” a future premium that exceeds the cost of cheating

7. Vertical Integration vs. Long-Term Market Contract • When will vertical integration be observed as a solution and when will the use of the market-contracting process occur? “…the lower the appropriable specialized quasi rents, the more likely that transactors will rely on a contractual relationship rather than common ownership. And conversely, integration by common or joint ownership is more likely, the higher the appropriable specialized quasi rents of the assets involved.” (p. 307)

8. Appropriable Specialized Quasi-Rent Example: Automobile Manufacturing 1919: GM and Fisher enter into 10-yr contract for closed bodies with an exclusive dealing clause Post-contractual opportunistic threat Post-contractual opportunistic threat 1924: Demand for closed bodies has drastically increased and Fisher is being opportunistic (won’t adjust price and won’t move closer to GM)  appropriable quasi-rents increase 1926: GM acquires Fisher

9. Thank You!