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The Choice of Organizational Form: Vertical Financial Ownership versus

Other Methods of Vertical Integration (Joe Mahoney, SMJ 1992)

I-Chen Wang

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Distinction between Concepts

Vertical Financial Ownership (VFO henceforth)

Elimination of contractual or market exchanges + substitution of internal transfers within the boundaries of the firm

Vertical Contracting (VC henceforth)A variety of contractual relationship, e.g. resale price maintenance, exclusive dealing, franchising, etc.

VFOMkt. Intermediate forms of VC

Vertical Integration

Vertical integration strategyIn the absence of agency theory and transaction costs, vertical financial ownership and vertical contracting are equivalent governance structures for achieving corporate objectives.

Research question: When market mechanisms are sufficient, when intermediate forms of vertical contracting become necessary, and when vertical financial ownership becomes the preferred governance structure

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To Overcome Market Failures

Market failures call for “institutions of capitalism”

Causes of market failures:OpportunismEnvironment uncertainty/complexity + bounded rationalityAsymmetric informationSmall numbers bargaining situation + asset specificity

Vertical integration Strategic considerations

Eliminate competition, e.g., oil refiner

Output and/or input price discrepanciesEliminate monopoly power from each production stage, minimizing risk of appropriation

Uncertain costs and pricesHolding asset specificity constant, VI increase with uncertainty (TCE); but, increase in uncertainty leads to less specialized assets (Harrigan)Output measurability, shirking

ADVANTAGES OF VFO

Transaction costs theory suggests the following:

Profit – eliminate preemptive claims on profits between separate firmsCoordination and Control – better control of opportunistic behavior due to authority relationships; disputes handled more effectivelyAudit and Resource Allocation – ability to audit whole firm; ability to control all resourcesMotivation – solidarity and clan-like emotionsCommunication – improved coding system

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The Disadvantages of VFO

Bureaucratic costs• Implementation costs• Loss of high-powered market incentives• High internal costs

Strategic costs• Loss of access to info. and tacit knowledge• Increasing sunk cost and/or chronic excess capacity• Over psychological commitment

Production costs• Cost disadvantages without minimum efficient scale• Capital drain• Capacity imbalance

----VFO is not sufficient to meet those considerations!

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To Integrate VFO, VC and TCs

Dimensions of transaction costsFrequency: occasional or recurrent transactionsUncertainty: demand and technologicalAsset specificity: human, physical and/or site firm-specific investments

Dimensions of agency costsNon-separability problems: asymmetry info. b/w output and effortTask programmability: knowledge of the transformation process

Proposition

Non-separability, programmability (agency theory Information asymmetry), specificity (TCE) are three factors to suggest the vertical ownership decision

Low task programmability

High task programmability

Low specificity

High specificity

Low specificity

High specificity

Low non-separability

Spot market Long-term contract

Spot market Joint venture

High non-separability

Relationship contract

Clan (hierarchy)

Inside contract

Hierarchy

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Contributions and Implications

Theoretical contributionsPropose a general theory of vertical integration strategyFill in the research gap by incorporating the vertical governance structure comparisonIntegrate the agency and transaction costs theory

Empirical implicationsEmpirical study on the three variables are warrantedWhether the dimensions of TCs specified here are “sufficient statistics” for predicting organization formWhether the efficiency orientation alone is adequate to predict organization form