Presented by Jenna Moore, BADM 545 Fall 2013

1. The Choice of Organizational Form: Vertical Financial Ownership Versus Other Methods of Vertical IntegrationJoseph Mahoney, SMJ, 1992 Presented by Jenna Moore, BADM 545 Fall 2013

2. OVERVIEW • Purpose: To provide an integrative framework for predicting and prescribing organizational form of vertical control (Table 3, p. 576) • Synthesizes empirical evidence from economics and strategy • Applies insights from agency and transaction cost theory • Structure of Paper: • Advantages of vertical integration: purported motives • Isomorphic nature of vertical financial ownership and vertical contracting • General theory for predicting patterns of vertical financial ownership and vertical contracting in different environments: Integrating transaction costs and agency theory

3. Advantages of Vertical Integration Strategy • Motives allegedly explaining vertical financial ownership: • strategic considerations—increasingbarriers of entry (‘price squeezing’), foreclosing competitors, raise competitors’ costs • output/input price advantages—successive monopoly, bilateral monopoly, upstream monopoly • Uncertainties in costs/prices—minimize risks associated with supply and demand uncertainties, measurement and quality uncertainties *Problem: motives provide explanations for vertical coordination, but do not provide prescriptions on choice of governance structure

4. Isomorphic Nature of Vertical Integration and Contracting • Vertical contracting (e.g., resale price maintenance, exclusive dealing) = alternative to vertical financial ownership • Offers illustration of isomorphism by addressing each of the 3 preceding motives using vertical contracting instead of vertical financial ownership • Main point: In the absence of transaction costs, vertical contracting and vertical financial ownership are interchangeable

5. Two Branches of Agency Theory • Mathematical principal agent models • Ignores problems of bounded rationality and transaction costs (‘Coaseanworld’) • The firm is viewed as a “nexus of contracts” • Organizational form is irrelevant • 2) Positive agency theory • Agency costs are subset of transaction costs • Costs include: monitoring and bonding expenditures, and the residual loss

6. Advantages of Vertical Financial Ownership • According to transaction costs theory, the following advantages are generated by vertical financial ownership: • Preemptive claims on Profit • Coordination and control • Audit and resource allocation • Motivation • Communication • Conclusion: when a firm vertically integrates, changes occur that relate to governance structures, incentives, and ownership

7. Disadvantages of Vertical Financial Ownership • But should vertical financial ownership be chosen based on governance structure, ownership, and incentive advantages? • Making this decision based solely on organizational economics is limited; lacks a comparative institutional assessment • When considering implementation problems, strategic management researchers have uncovered the following disadvantages: • Bureaucratic costs • Strategic costs • Production costs

8. Framework For Predicting Organizational Form • Recall: transaction costs approach considers asset specificity but ignores interactive effects of measurement problems • Positive agency theory considers interactive effects of measurement problems but ignores asset specificity • The integration of these two perspectives allows for predictions and prescriptions to be made regarding choice of governance structure • Essentially 8 different circumstances that might face the firm (see Table 3)

10. Conclusion • Integrating strategy and economics allows us to gain new and interesting theoretical insights • A synthesis of the agency and transaction costs literatures allowed for the creation of an integrative framework used to predict and prescribe the optimal vertical governance structure • Future research should investigate empirically whether or not the relationships within this framework do in fact predict organizational form