The Economics of Vertical Integration and Hybrid Forms

Manuel González-Díaz

UNIVERSIDAD DE OVIEDO (SPAIN)

Cargèse, May, 6th

VI Definition: bringing two or more successive stages in production and/or distribution under common ownership.

Vertical Integration and Hybrids Forms

Raw materials

Frame and roof

Installations: plumbing, heating, hot water

Finishing: floors, painting

Real state

Forward integration

Backward integration

Upstream

Downstream

Hybrids

Market and hierarchies are polar governance mechanisms

Many organizations do not follow any of these types of governance mechanism

There is a “continuum” of governance forms between them called “hybrids”

“Advanced” subcontracting (quasi-integration), franchising, management contracts, joint ventures and alliances are some hybrids.

Market HierarchyHybrids

Structure of talk

• How transaction costs influence VI and hybrids through the nature of the transactions (dimensions)

• Economizing and analysis of discrete structural alternatives

• Opening the black box of governance: Incentives and coordination (adaptation)

• Changing parameters: – Institutional parameters

• “Tournament” of prediction capacity among organizational theories

Make-or-Buy decisionMake or buy is a paradigmatic problem in NIE

Why arm’s length transactions are sometimes more costly than hierarchical transactions?

Since transaction is the unit of analysis, differences could be in the features of transactions

They are different dimensions/features

• Specificity

• Uncertainty

• Frequency and duration

• Measurement difficulties

• Connectedness

SpecificityAccording to Williamson (1985, 1996), this is the most relevant dimension of transactions

Investments in specific assets may create a risk of hold-up, specially when assets create quasi-rents which are high and expropriable.

Quasi-rent is the portion of earnings in excess of the minimum amount needed to prevent an economic agent from exiting its activity. Q=VP-VA

Quasi-rents are not always expropiable (investment in publicity). They act then as a safeguard instead as a contractual hazard.

Specificity IIThe sources of the quasi-rent can be:

Site (pipeline)

Physical (specialized mold)

Human assets + brand name capital (intangible assets)

Temporal (soft fruit perishability)

Dedicated assets (the expansion in facilities is necessitated only by the requirements of a few buyers)

The higher the specificity, the larger the vertical integration

Uncertainty Williamson (1975, 1985) argues that uncertainty (difficulty of foreseeing the evolution of transactional variables) increases transaction costs (i.e. increases the costs of establishing how participants should act in each possible contingency).

Although it is present in both markets and hierarchies, the problem is smaller within organizations because they are more flexible: there is an ex ante agreement about the allocation of residual decision rights

General hypothesis: The greater the uncertainty, the larger the vertical integration

Complexity uncertainty VI

Specificity & uncertainty VI (interactive effect)

More on Uncertainty There are several sources of uncertainty

Clients (demand) - VI (short run; capacity subcontracting)

Technology (production process, new products)

- VI (which technology?)

+ VI (Are there any technological provider?)

Suppliers +VI (backward)

Managers integrate activities which correlate negatively with the firm’s profits (to reduce profits variance) ? VI

Frequency and DurationFrequency VI

arm’s length negotiations are too costly for repeated transactions

hierarchy (or hybrids forms) facilitates the design and the introduction of low-cost routines to manage repeated transactions

Duration (length of the contract) VI

the longer the period over which contractors interact, the more difficult it will be to foresee relevant contingencies (uncertainty argument?)

if a long period is divided in many independent short contracts (voluntary renewal), reputation may overcome previous problems

Measurement difficulties

Non explicitly contractible attributes (difficulty of measuring performance) negatively affect both hierarchy and market performance, but stronger on market VI

Hierarchy can use authority and behavioral monitoring

Residual claimant has residual control proper incentives

Several tasks difficulty of measuring individual performance task aggregation VI

Connectedness

Transaction differ in how they are connected to other transactions (independency)

Strongly complementary assets VI

Coordination difficulties VI

Summing up

Nature of transactions (dimensions)

Transaction Cost

Bounded rationality

Opportunism

Behavioral assumptions

Observed organizational

form

• Specificity• Uncertainty• Frequency/duration• Measurement

difficulties • Connectedness

•For empirical references to these arguments, see Joskow (1988) Shelanski and Klein (1995) and Boerner and Macher (2003)

•However, as Williamson (1996) and Masten (1993) have argued, and was considered by Poppo and Zenger (1998), this is a partial view of the problem of the organizational choice

Transaction Cost Framework

Nature of transactions (dimensions)

TC before G

(TCb)TCGi

“Dominant” Form

Investment in Safeguards and

Governance Mechanisms (Gi)

TCG1

TCG2

TCGnGn

G1

G2

...

...Gi

n discrete governance structures

Bounded rationality

Opportunism

Behavioral assumptions

Transaction Cost Framework II

Nature of transactions (dimensions)

TC before G

(TCb)TCGi

“Dominant” Form

Rule 1: TCb > TCGi

(Economizing)

Investment in Safeguards and

Governance Mechanisms (Gi)

TCG1

TCG2

TCGnGn

G1

G2

...

...Gi

Rule 2: Min TCGi

(Discriminating alignment)

Masten’s argument (1993)

The relation between governance and performance cannot be accurately assessed without an appreciation of the factors that lead transactors to adopt one form of organization over another.

We have to regress each governance form performance on their transaction cost variables.

Gf=firm; Gm=market; G*= observed chosen governance form

Cf= Costs of internal transaction; Cm= costs of market transact.

G*=Gf if Cf<Cm and G*=Gm if Cf>Cm

Cf=aX+e and Cm=bX+u; then P(Cf<Cm)=P(e-u)<(b-a)X

Predictions of organizational form can then be based on the sign of (b-a), i.e. on the differential effect of attributes of the transactions of the cost of organizing.

Poppo and Zenger’s paper (1998)

Mechanisms of Governance : Incentives and coordination

• Mechanisms of governance economize transaction costs depending on their capacity to solve transaction problems

• Incentive intensity and coordination capacity are the main features in which governance mechanisms differs each other.

• Vertical integration and hierarchy are polar in this sense. Hybrids share features with both structures.

• Understanding the chosen structure requires to know key problems in each situation

• Baker and Hubbard (2003) show how the importance of opportunisms (incentive) and coordination helps to explain assets ownership (i.e. the governance mechanism)

Baker and Hubbard (2003)

• The pattern of ownership (VI versus hierarchy) reflects: – not only the trade-off that arise from providing intermediaries

strong incentives to identify profitable uses for assets (Grossman and Hart’s argument (1986) about incomplete contracts),

– but also job design and measurement issues because complex combination of tasks hinders intermediaries’ ability to find profitable uses for assets.

• Static predictions: – service-intensive trucking is more likely to be performed by

private (VI) than for-hire fleets (market).– Private fleets (VI) are differentially more likely to adopt

incentive–improving technologies while for-hire carriers (market) are more likely to adopt coordination–improving technologies

Baker and Hubbard (2003)

• Dynamic predictions (how changes in the IT environment affect the boundaries of the firm): – The adoption of monitoring–improving technologies

lead indirectly to more shipper ownership of truck (VI) (trip recorders) while

– The adoption of coordination–improving technologies lead to less shipper ownership of trucks (market) (EVMS).

• Generally?: – Improvements in monitoring lead to VI– Improvements in coordination lead to market

An Step Further

• Williamson (1991) have considered governance cost as a function of specificity (dimensions) and a “vector of shift parameters” M=f(k,)

• Previous arguments and many of the quoted papers assume as constant that vector of shift parameters

• Shift parameters are for example the institutional environment (contract law, tax system, etc.)

• A change in those parameter yield a shift in the intercept and/or the slope of the governance cost curve (regarding a transaction dimension)

Governance cost and shift parameters

Source: Williamson 1991

M1(k)M3(k)M2(k)

Institutional environment and VI

• These shifts may change the chosen organizational form• This perspective is clearly NIE• Deals with any type of regulation (labor, contractual,

industry and tax regulation)• Research opportunities since literature is relatively scarce.

Some references: González-Díaz, Arruñada and Fernández (1998), Nickerson and Silverman (2004), Lafontaine and Oxley (2004), Arruñada, González-Díaz and Fernández (2004). See also labor economics literature.

• Time series analysis, panel data or, at least, two observations in different periods (countries) are required.

Comparing theories

• VI has also been used as mean to compare the prediction capacity of TCE and other theories.

• TCE, Resource Based View, Knowledge Based View and Property rights are the most common.

• Poppo and Zenger’s paper (1998) is an example (Adds Knowledge-Based theory and measurement issues). Their main “new” arguments:– The greater the specificity of activities (language), the greater the

efficiency with which such activities are coordinated through internal governance: routines, which are firm-specific, enhance the performance of an activity (Result: rejected).

Poppo and Zenger’s paper (1998)

• Main new arguments tested (continued) – Increased difficulty in measuring the performance of an

activity will have a weaker negative effect on the performance of internally governed exchanges than on market-governed exchanges (Result: rejected).

– The net effect of technological uncertainty on firms boundaries depends on the form of tech. uncertainty: if it mandates coordination adaptation, encourages integration (result: rejected).

– An increase in the scale of internal demand for an activity increases the likelihood of vertical integration. (Result: supported)

– The larger the skill set required, the lower the internal performance (result: supported)

Summing up again

Analyzing governance mechanisms requires to:• Understand the nature of the transactions

(dimensions) and to know costs generated under each governance mechanisms

• Compare discrete structural alternatives regarding:– Incentives – Coordination

• Observe the effects of other parameters (institutional and technological parameters).

. . . This is the end