Alternatives to Vertical Integration

1
Lecture 6

• Alternatives to Vertical Integration

2
Property Rights Approach

• Until recently, was generally considered as the
  most convincing explanation to describe vertical
  relationships
• Over the last five years, a more critical view
  has started to emerge
• Today discuss why people are dissatisfied
• Next week describe new explanations

3
Critical View

• Firms are complex mechanisms for coordinating and
  motivating individuals activities
• Provision of investment incentives and the
  resolution of the hold-up problem is not the only
  things that firms care about

4
Incentives Not All

• Ownership patterns are not determined only by the
  need to provide incentives
• Incentives for investment are provided by a
  variety of means, of which ownership is only one

5
How Does It Work in the Real World?

• There are situations where contracts are
  incomplete, where relationship-specific
  investments appear quite high, yet the patterns
  of ownership can not be explained by property
  rights theory or the transaction costs theory
• Example car industry in the US compared to Japan

6
Other Contradiction

• There other situations where the holdup problem
  appears to be small, so that the boundaries of
  the firm must be driven by other aspects
• These examples suggest that ownership patterns
  are responsive to, among other things, agency
  problems, concerns for common assets,
  difficulties in transferring knowledge, and the
  benefits of market monitoring

7
Problem with Property Rights Approach

• Firms are poorly defined (two individuals and two
  assets)
• Firms are composed by many individuals who have
  to coordinate their actions and be motivated to
  act in the interests of the firm

8
Relationship in the Japanese Car Industry

• Long term, close relationships with a limited
  number of independent suppliers
• Long term relations substitute for ownership in
  protecting specific assets
• In Japan, suppliers often design the parts that
  they supply to the buyer not true in the US
• Same for the ownership of the dies

9
What Does That Mean?

• These divergence in the practice between the two
  countries presents problems for attempts to
  explain ownership allocation solely in terms of
  providing incentives for investment

10
Japanese and Contracts

• Explicit contracting is not used to overcome the
  incentive problems involved in outsourced design
  and ownership of specific assets
• Contracts are short, vague
• Key to the system long term, repeated nature of
  the relationship

11
Repeated Games

• Attempts to hold-up your partner can be punished
• Renewal of contracts based on performance
• Rewards/punishments facilitated by the constant
  redesigns

12
Small Number of Suppliers

• Essential component of the system
• Reduces monitoring costs
• Increases frequency
• Both elements strengthen the force of reputation
• Example Toyota uses two suppliers

13
Information Sharing

• Schedule of production plans
• Production process itself
• Info asymmetries are reduced, what facilitates
  performance evaluation and pricing negotiations

14
Other Examples

• Nucor mini-mills
• Volkswagen in Brazil
• Airline alliances KLM-Northwest
• Contractual assets control over assets can be
  contracted ex. BSkyB

15
Other Factors Determine Firms Boundaries

• Agency issues
• Example Electronic parts companies
• McDonalds and different types of franchise
• Gasoline retail few specificities
• Market monitoring
• Example Thermo Electron Corporation
• Knowledge transfer
• Example BP, ABB