The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration Sanford J. Grossman

1. The Costs and Benefits of Ownership: A Theory of Vertical and Lateral IntegrationSanford J. Grossman and Oliver D. Hart Prepared by Group 2: Enrique, Lihong, John, Jongkuk

2. Introduction • Coase (1937) suggested that transactions will be organized in the firm when the cost of doing this is lower than the cost of using the market (transaction cost based argument for integration) • Klein (1978) and Williamson (1979) argued that a contractual relationship is determined by opportunistic behavior between parties (asset specificity argument for integration) • Grossman and Hart (1986) argue that these two theories do not explain how the scope for such behavior change when one of the self-interested owner becomes an equally self-interested employee of the other owner.

3. Introduction • Grossman and Hart (1986) argue that these two theories can not answer the question of what limits the size of the firm. • They question the definition of integration used by these two theories – What does it means for one firm to be more integrated than another? • Grossman and Hart (1986) define integration in terms of the ownership of assets and develop a model to explain when one firm will desire to acquire the assets of another firm.

4. What is integration? • There is no difference between employees and outside contractors in the case in which the firm provides all the tools and the other assets used by contractors. • Insurance companies may use own employees as commissioned agents or use independent agents • Shoe manufacturing in eighteen century • The issue of ownership can be separated from the issue of contractual compensation • A firm may pay another firm or person a fixed amount or salary irrespective of the ownership of the machines. • They assume that integration in itself does not make any new variable observable to both parties • Any audit that an employer may have done of his subsidiary is also feasible when the subsidiary is a separate company

5. Type of control rights • Theory of costly contracts that emphasizes that contractual right can be: • Specific rights – written contractual provisions over assets • Residual rights – the right to control all aspects of the asset that have not been explicitly given away by contract. • Ownership is the purchase of residual rights of control.

6. Model Assumptions • The relationship between parties last two periods • None of the production decision (q) is ex-ante contractible, so the contract at the time 0 only allocates ownership of residual rights • (q) is ex-post contractible - Once the state of the world is determined, parties can renegotiate costlessly. • Symmetric information – lead to ex-post efficient allocation, however the distribution of ex-post surplus is sensitive to ownership rights. • Ex: printer ( second print run) • Ex-post surplus ownership rights affects ex-ante investment decision – each ownership structure lead to a different distortion in ex-ante investments. • Optimal contract must maximize the total ex-ante net benefits of the two managers or parties allocate ownership right so the ex-ante investments distortions are minimized.

7. Model specification • The theory involves two units that can enter into a productive venture. Each unit has two types of decisions to make: • investment in relationship-specific assets (this decision is non-contractible) • operating decisions (this decision is contractible) • Net benefits to each are • B1(a1,f1(q1,q2)) and B2(a2,f2(q1,q2)) • ai = relationship-specific investments • qi =production decisions of firm I • The two units negotiate over what operating decisions to make. But if the negotiation breaks down, the owner of the relevant asset has the right to make the operating decision. Such right of control confers the owner bargaining power over the division of quasi-rents from the operating decisions. • This in turn affects the incentive to invest in relationship-specific assets, and hence the total surplus from cooperation.

8. The sequence of decisions • In stage 1, each unit decide on their level of relationship specific investments (ai). Such investment is not verifiable by third parties. • In stage 2, each unit decide on the production levels (qi). The decision is affected by the structure of ownership. • If the two units are not integrated, unit 1 decides q1 and unit 2 decides q2. • If unit 1 owns unit 2, then unit 1 decides both q1 and q2. • If unit 2 owns unit 1, then unit 2 decides both q1 and q2. • In stage 3, the two units renegotiate on the production decisions. The renegotiation takes place because the decisions in stage 2 do not maximize joint surplus. The allocation of the gains from a more efficient production decision will depend on the "status quo" determined in stage 2. • In this framework, the idea of ownership is related to the notion of control rights. Ownership of a unit renders the owner the right to control the production decision (subject to renegotiation). Implicitly we are assuming such control rights cannot be directly exchanged (except by a transfer of ownership).

9. Full efficiency • Let variables with an asterisk denote the fully efficient outcome (not achievable). Then • q1* maximizes B1 + B2. • q2* maximizes B1 + B2. • a1* maximizes B1. • a2* maximizes B2.

10. Case 1: Non-integration • Let variables with a superscript “s2" denote the production decisions in stage 2. Then • q1s2 maximizes B1. • q2s2 maximizes B2. • In stage 3, they will renegotiate and arrive at the more efficient decisions, q1* and q2*. They then divide the gain from re-contracting 50-50. Therefore, the overall payoff to unit 1 is • B1(a1,f1(q1s2,q2s2))+(1/2)[B1(a1,f1(q1*,q2*))+B2(a2,f1(q1*,q2*))-B1(a1,f1(q1s2,q2s2)) -B2(a2,f1(q1s2,q2s2))]

11. Case 1: Non-integration • In stage 1, unit 1 chooses a1 to maximize the expression in the previous slide. The optimal choice of a1 is characterized by • (1/2)[d B1(a1ni, f1(q1*, q2*))/d a1] + (1/2)[d B1(a1ni, f1(q1ni, q2ni))/d a1] = 0. • In contrast the fully efficient choice of a1 is characterized by • d B1(a1*, f1(q1*, q2*)/d a1 = 0.

12. Case 2: Firm 1 owns Firm 2 • Let variables with a superscript "1o2" denote the production decisions in stage 2. Then • q11o2 maximizes B1 • q21o2 maximizes B1 • In stage 3, they will renegotiate and arrive at the more efficient decisions, q1* and q2*. They then divide the gain from re-contracting 50-50. Therefore, the overall payoff to unit 1 is • B1(a1,f1(q11o2,q21o2))+ (1/2)[ B1(a1,f1(q1*,q2*)) +B2(a2,f1(q1*,q2*))-B1(a1,f1(q11o2,q21o2)) -B2(a2,f1(q11o2,q21o2))]

13. Case 2: Firm 1 owns Firm 2 • In stage 1, unit 1 chooses a1 to maximize the above expression. The optimal choice of a1 is characterized by • (1/2)[d B1(a11o2, f1(q1*, q2*))/d a1] + (1/2)[d B1(a11o2, f1(q11o2, q21o2))/d a1] = 0 • For the case where firm 2 owns firm 1 the solution is similar

14. Comparisons • If f1 = g1(q1) + e h1(q2) and • f2 = g2(q2) + e h2(q1), and e is "small," then non-integration is best. • If f2 = g2 + e h2(q1,q2), then 1 owns 2. • If f1 = g1 + e h1(q1,q2), then 2 owns 1. • Assume the prior investment decision and the subsequent production decisions be complements in the net benefit functions. The sources of inefficiency are • non-integration: a1ni < a1*; a2ni < a2* • 1 owns 2: a11o2 > a1*; a21o2 < a2* • 2 owns 1: a12o1 < a1*; a22o1 > a2*

15. The nature of the investment distortions

16. An application • The list of clients is an important asset in the insurance business. Under non-integration, the insurance agent controls this asset; under forward integration, the insurance firm controls it. • Building and maintaining a client list requires investments by both the agent and the insurance company. If the company owns the client list, it can threaten to do things that reduce the likelihood of renewal (e.g., raising premiums) unless the agent accepts a cut in his commission. • Faced with the possibility of this hold-up problem, the agent will under-invest in searching and maintaining the client list. • If the agent owns the client list, he could also threaten to do things that reduce the likelihood of renewal (e.g., lowering the service quality) unless the company raises his commission. • Faced with this hold-up problem, the company will under-invest in building and maintaining the client list.

17. An application… • Thus the choice between an in-house sales force (company-owned list) versus independent agents (agent-owned list) depends on whether company underinvestment or agent underinvestment is the more important problem. • A purchaser of whole life insurance is much less likely to switch insurance companies than a customer of fire insurance. Thus the agent's effort in searching out persistent clients is less important for whole life insurance than for fire insurance. • The theory then predicts that whole life insurance are more likely to be company-owned while fire insurance are more likely to be agent-owned. This implication is consistent with industry practice.