The Choice of Organizational Form: Vertical Financial Ownership versus Other Methods of Vertical Integration (Joe Mahone

1. The Choice of Organizational Form: Vertical Financial Ownership versus Other Methods of Vertical Integration (Joe Mahoney, SMJ 1992) Prepared by: Enrique, Lihong, John, Jongkuk

2. Vertical Integration Mkt. Intermediate forms of VC VFO Distinction between Concepts (1) • 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.

3. Distinction between Concepts (2) • Positive agency theory Vs. Mathematical principal-agent models • Unavoidable agency costs among the principal-agent relationships • Unbounded rationality of agents and no differential costs between long-term contracts and hierarchy • Positive agency costs Vs. transaction costs (TCs) • Monitoring costs, bonding costs and residual loss • Ex ante TCs and Ex post TCs

4. Purpose • To synthesize literature concerning VFO and VC from industrial organization and strategy • To analyze the contingent relationship between VFO and VC • If transaction costs and agency costs are assumed away, VFO=VC • Otherwise, simple distinction between VFO and VC is inadequate • To inquire into the governance structure choice given different scenarios of agency costs and transaction costs

5. Advantages of VFO • Transaction costs consideration • In terms of market failure • Strategic consideration • In terms of competitive advantage (CA) • Output and/or input price • In terms of monopoly power • Uncertainty in costs and/or prices • In terms of stochastic elements

6. To Overcome Market Failures • Market failures call for “institutions of capitalism” • Causes of market failures • Opportunism • Environment uncertainty/complexity + bounded rationality • Asymmetric information • Small # bargaining situation + asset specificity • Advantages of VFO • Profit incentive • Coordination and control • Audit and resource allocation • Motivation • Communication Back

7. To Strengthen CA • Erect entry barriers: e.g. foreclose competitors; raise rivals’ costs; build exit barrier; use price squeezing • Transfer pricing to evade regulation • Maintain oligopolistic discipline • Provide mobility barrier Back

8. To Smooth Price Discrepancies • Successive monopoly case: to evade monopoly price by upstream firms • Bilateral monopoly case: to minimize risk of rent appropriation • Upstream monopoly case: to achieve efficiency in resource utilization • Intermediate good monopoly case: to eliminate price discrimination incentives Back

9. To Reduce Uncertainty • Uncertainty is multifaceted • General theoretical agreement on the relationship b/w uncertainty and VFO • Specific disagreement on the relationship b/w demand uncertainty, tech. uncertainty and VFO • Empirically, the relationship b/w VFO and uncertainty is contingent on the positive agency and transaction costs

10. What can VC do? • Strategic reason: entry barrier, transfer pricing and oligopolistic pricing • Output/input price: control of prices • Uncertainty: insure product quality and service, and alleviate problems such as tech. uncertainty, info. trading difficulty and externality ---- In the absence of transaction costs, VC can replicate the advantages of VFO!

11. The Isomorphic Nature of VFO and VC (2) ----VFO is not necessary to meet those considerations!

12. 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!

13. 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

14. A Model of Governance Structure 1 2 5 6 3 4 7 8

15. 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