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Understanding Vertical Financial Ownership Versus Vertical Contracting

A comprehensive analysis comparing Vertical Financial Ownership and Vertical Contracting in terms of agency costs, transaction costs, advantages, disadvantages, and governance structures. Examines how each form impacts market failures, competitive advantage, and uncertainty within organizations.

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Understanding Vertical Financial Ownership Versus Vertical Contracting

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  1. The Choice of Organizational Form: Vertical Financial Ownership versus Other Methods of Vertical Integration (Joe Mahoney, SMJ 1992) Prepared by: Enrique, Lihong, John, Jongkuk

  2. Vertical Integration Mkt. Intermediate forms of VC VFO Distinction between Concepts (1) • 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.

  3. Distinction between Concepts (2) • Positive agency theory Vs. Mathematical principal-agent models • Unavoidable agency costs among the principal-agent relationships • Unbounded rationality of agents and no differential costs between long-term contracts and hierarchy • Positive agency costs Vs. transaction costs (TCs) • Monitoring costs, bonding costs and residual loss • Ex ante TCs and Ex post TCs

  4. Purpose • To synthesize literature concerning VFO and VC from industrial organization and strategy • To analyze the contingent relationship between VFO and VC • If transaction costs and agency costs are assumed away, VFO=VC • Otherwise, simple distinction between VFO and VC is inadequate • To inquire into the governance structure choice given different scenarios of agency costs and transaction costs

  5. Advantages of VFO • Transaction costs consideration • In terms of market failure • Strategic consideration • In terms of competitive advantage (CA) • Output and/or input price • In terms of monopoly power • Uncertainty in costs and/or prices • In terms of stochastic elements

  6. To Overcome Market Failures • Market failures call for “institutions of capitalism” • Causes of market failures • Opportunism • Environment uncertainty/complexity + bounded rationality • Asymmetric information • Small # bargaining situation + asset specificity • Advantages of VFO • Profit incentive • Coordination and control • Audit and resource allocation • Motivation • Communication Back

  7. To Strengthen CA • Erect entry barriers: e.g. foreclose competitors; raise rivals’ costs; build exit barrier; use price squeezing • Transfer pricing to evade regulation • Maintain oligopolistic discipline • Provide mobility barrier Back

  8. To Smooth Price Discrepancies • Successive monopoly case: to evade monopoly price by upstream firms • Bilateral monopoly case: to minimize risk of rent appropriation • Upstream monopoly case: to achieve efficiency in resource utilization • Intermediate good monopoly case: to eliminate price discrimination incentives Back

  9. To Reduce Uncertainty • Uncertainty is multifaceted • General theoretical agreement on the relationship b/w uncertainty and VFO • Specific disagreement on the relationship b/w demand uncertainty, tech. uncertainty and VFO • Empirically, the relationship b/w VFO and uncertainty is contingent on the positive agency and transaction costs

  10. What can VC do? • Strategic reason: entry barrier, transfer pricing and oligopolistic pricing • Output/input price: control of prices • Uncertainty: insure product quality and service, and alleviate problems such as tech. uncertainty, info. trading difficulty and externality ---- In the absence of transaction costs, VC can replicate the advantages of VFO!

  11. The Isomorphic Nature of VFO and VC (2) ----VFO is not necessary to meet those considerations!

  12. 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!

  13. To Integrate VFO, VC and TCs • Dimensions of transaction costs • Frequency: occasional or recurrent transactions • Uncertainty: demand and technological • Asset specificity: human, physical and/or site firm-specific investments • Dimensions of agency costs • Non-separability problems: asymmetry info. b/w output and effort • Task programmability: knowledge of the transformation process

  14. A Model of Governance Structure 1 2 5 6 3 4 7 8

  15. Contributions and Implications • Theoretical contributions • Propose a general theory of vertical integration strategy • Fill in the research gap by incorporating the vertical governance structure comparison • Integrate the agency and transaction costs theory • Empirical implications • Empirical study on the three variables are warranted • Whether the dimensions of TCs specified here are “sufficient statistics” for predicting organization form • Whether the efficiency orientation alone is adequate to predict organization form

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