the costs and benefits of ownership: a theory of vertical and lateral integration
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The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration. Sanford J. Grossman, Chairman and CEO of QFS Asset Management. Oliver D. Hart, Professor of Economics at Harvard University. Overview. - PowerPoint PPT PresentationTRANSCRIPT
The Costs and Benefits of Ownership: A Theory of Vertical and Lateral
Integration
Oliver D. Hart, Professor of Economics at Harvard
University
Sanford J. Grossman, Chairman and CEO of QFS
Asset Management
Slides prepared by Jenna Moore, BADM 545
OverviewResearch Questions: (1) What determines how vertically or
laterally integrated the activities of a firm are? (2) Are there costs and benefits associated with ownership?
Conventional wisdom: incomplete contracts non-integrated relationship inferior outcomes (compared to complete contracts) transactions cost-based theory (e.g., Coase, 1937) suggested that
integration occurs when cost of doing so is less than cost of using the market
Klein et al. (1978) and Williamson (1979) identified probability of opportunistic behaviors
Assumes integration always leads to outcomes consistent with complete contracts
Overview
In contrast, Grossman and Hart (1986) argue that there is symmetry of control:When residual rights are purchased by 1 party,
they are lost by a 2nd party, and this leads to distortions
Opportunistic and distortionary behaviors are not removed, only shifted
Purpose
(1) Present a theory of costly contractsContractual rights can be of two types: specific and
residualSometimes it is too costly to specify all rights over
assetsAlternative: one party purchases all residual rights
(2) Develop a theory of integration based on the attempt of firms to efficiently allocate residual rights of control
What is integration?Defined by Grossman & Hart as ownership of
assets (non-human: e.g., machines, inventories)Ownership = the purchase of residual rights of
controlBecause contracts are incomplete, the ex post
allocation of power (or control) mattersWhat are the costs and benefits of integration?
Grossman & Hart present a model
Method
Presented a formal model of relationship between 2 firms Relationship is either vertical or lateral
Relationship lasts over 2 periods of time: ex ante (when each manager makes relationship-specific investments) and ex post (when production decisions are made and benefits realized) Basic assumption: no aspect of production decisions is ex
ante contractibleGrossman and Hart present the model in detail, and
then apply results to a firm in insurance industry
Model
Assumptions: (1) all variables are ex ante non-contractible
(2) investments by managers 1 and 2 are chosen simultaneously and non-cooperatively(3)there is a competitive market in identical potential trading partners at date 0
Analysis of Optimal Contract
Optimal contract: maximizes one manager’s benefit subject to the other manager’s receiving his reservation utility
Case 1: Non-integrationCase 2: Firm 1 controlCase 3: Firm 2 control
Determining distortions associated with different ownership structures
Results
The following tradeoffs were elucidated: When is firm 1 control desirable? When firm 1’s ex ante
investment is more important than firm 2’s, and when over-investment by firm 1 is less severe problem than under-investment by firm 1
When is firm 2 control desirable? When same conditions above are satisfied for firm 2
When is non-integration desirable? When firm 1 and firm 2 investments are equally important (preferable for both to be at a medium level)
*Main result: optimal ownership structure is chosen to minimize overall loss in surplus that is due to investment distortions
Application of theory to insurance industry
Grossman & Hart use their framework to analyze the determinants of who owns the list of policyholders (i.e., the only asset in this case)
They illustrate that the trade-offs between different ownership structures are the same as in their formal model
Conclusions
Sometimes it is too costly for one party to list all of the specific rights it desires over another party’s assets In that case, ownership of residual rights may be optimal
Grossman and Hart emphasized the symmetry of control Integration only shifts incentives for opportunistic and
distortionary behaviorsTheir model revealed the distortions that are due to
contractual incompleteness—these distortions can prevent a party from getting the ex post return needed to balance out his ex ante investment