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Vertical Integration, Appropriable Rents, and the Competitive Contracting Process. Journal of Law and Economics (1978). Benjamin Klein UCLA. Armen A. Alchian UCLA. Robert G. Crawford BYU. Presented by: Danielle Jones. Background. - PowerPoint PPT Presentation
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Vertical Integration, Appropriable Rents, and the Competitive Contracting ProcessJournal of Law and Economics (1978)
Benjamin KleinUCLA
Robert G. CrawfordBYU
Armen A. AlchianUCLA
Presented by: Danielle Jones
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Background• Coase (1937): Transaction, coordination, and contracting costs
are explicitly considered when determining the extent of vertical integration such that a firm will internalize all activities that are cheaper to conduct within the firm rather than contracting them in the market.
• Williamson (1975): Due to imperfect information, all transactions are subject to costs that stem from potential or actual opportunism.
– Opportunism = “self-interest seeking with guile”
• Teece (1976): Regardless of the degree of specificity of provisions in a contract, there will always be room for opportunism/reneging
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Main Idea of This Paper• Explores one particular cost of using the market: the
possibility of post-contractual opportunistic behavior
• Emphasizes the presence of appropriable specialized quasi rents as the motivation for contract reneging and opportunistic behavior
General Theory: • As assets become more specific, more appropriable quasi
rents are created, and the costs of contracting will increase relative to the costs of vertical integration
• Therefore….ceteris paribus, as appropriable specialized quasi rents increase, we are more likely to see vertical integration
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What are Quasi-Rents?
• Quasi-rent = the value of an asset’s next best use to another renter; excess of asset value over salvage valueQR = AV - SV
• Appropriable quasi-rent = portion of quasi-rent (if any) in excess of its value to the 2nd highest-valuing userAQR = QR - NHV
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Quasi-Rent Example• Party A = printing press owner
– $1,000 salvage value; $1,500 operating costs• Party B = publisher B
– Pays $5,500 for printing services• Party C = publisher C
– Will offer $3,500 for printing services• Quasi-Rent
= Revenue – operating costs – salvage value = $5,500 - $1,500 - $1,000 = $3,000
• Appropriable Quasi-Rent= Quasi-rent – next best quasi-rent = $3,000 - ($3,500 - $1,500 - $,1000) = $2,000
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Mitigating Opportunistic Behavior
If appropriable quasi-rents of an asset lead to opportunism, how can opportunistic behavior be mitigated?(1)Vertical integration (ownership)
– Costs exist, but they are not related to the extent of appropriable specialized quasi-rents
(2)Economically enforceable long-term contract– Costs are positively related to extent of appropriable specialized quasi-
rents– Explicit enforcement = Legally enforced by the gov’t or some other third
party institution• Very costly to write, monitor, enforce, and litigate
– Implicit enforcement = Enforced by the market mechanism of withdrawing future business if opportunistic behavior occurs (goodwill market enforcement mechanism)
• Commonly implemented by offering potential “cheater” a future premium that exceeds the cost of cheating
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Vertical Integration vs. Long-Term Market Contract
• When will vertical integration be observed as a solution and when will the use of the market-contracting process occur?
“…the lower the appropriable specialized quasi rents, the more likely that transactors will rely on a contractual relationship rather than common ownership. And conversely, integration by common or joint ownership is more likely, the higher the appropriable specialized quasi rents of the assets involved.” (p. 307)
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Appropriable Specialized Quasi-Rent Example: Automobile Manufacturing
1919: GM and Fisher enter into 10-yr contract for closed bodies with an exclusive dealing clause
Post-contractual opportunistic threat
Post-contractual opportunistic threat
1924: Demand for closed bodies has drastically increased and Fisher is being opportunistic (won’t adjust price and won’t move closer to GM) appropriable quasi-rents increase
1926: GM acquires Fisher
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Thank You!
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