The Choice of Organizational Form

1. Joshua Downs 8/31/2015 Anand RV 9/05/2017 The Choice of Organizational Form Vertical financial ownership versus other methods of vertical integration Mahoney, 1992. SMJ

2. Main Points • Presents a generalized theory for predicting organizational form • Integrates and extends previous work done under both the strategy and industrial organization paradigms • Key reasons for vertical integration • Strategic considerations, input and output price related, uncertainty in costs or prices • Why ownership may be unnecessary? • Other organizational forms may provide similar efficiencies • Advantages and disadvantages of financial ownership • Predicting the organizational form • Integrating agency and TCE • Motives cannot predict form; form cannot predict motives

3. Why Vertically Integrate? • Strategic motives (role of regulatory environment?) • Increase entry and exit barriers • Price squeezing • Output and/or input price advantages • VI can help evade monopoly prices charged upstream • 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 • Inconsistent findings on whether vertical integration reduces demand and technological uncertainty • 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 (and other types of uncertainty) • Key input quality and point of sale service • Disagreement regarding technological uncertainty and likelihood of VI (key: asset specificity)

4. Are contracts equivalent to ownership? • Contracting can address concerns that financial ownership also does • What are the advantages of doing so? • Equivalency proposition of Coase theorem • “The initial assignment of property rights does not matter” • Extend arguments for ownership to vertical integration and apply to long-term contracts

6. 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)

7. Advantages of 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 3rd 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

8. Disadvantages of 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)

9. What Should the 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/measurmentissues • Nonseparability (measurement of output) • Task Programmability (measurement of input; effort) • 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

11. Discussion questions • How much does industry matter in accurately predicting organizational form? • When search and information costs and monitoring and enforcement costs have decreased presumably due to the ease with which information can now be accessed and evaluated, will we see a decrease or an increase in vertical financial ownership? • A large literature suggests that vertical contracting can address some of the concerns that financial ownership can address (Table-1, Mahoney(1992)). Given that financial ownership has disadvantages : bureaucratic costs, strategic costs and production costs, to what extent are these costs also associated with vertical contracts. In other words, when are vertical contracts more appropriate than ownership?