Download Mahoney (1992)

The Choice of Organizational
Form: Vertical Financial
Ownership versus Other
Methods of Vertical Integration
(Joe Mahoney, SMJ 1992)
Prepared by:
Enrique, Lihong, John, Jongkuk
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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.
Vertical Integration
Mkt.
Intermediate forms of VC
VFO
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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
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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
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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
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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
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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
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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
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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
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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!
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The Isomorphic Nature of VFO and VC (2)
TCs
consideration
??????
Strategic
consideration
Exclusive territories, exclusive dealing,
long-term contract, vertical price-fixing,
quasi-integration, tying
VFO Output/Input
price
Uncertainty in
prices/costs
Exclusive territories, requirements contract,
exclusive dealing, franchise, vertical pricefixing, forcing tie-in purchase
Long-term contract, Exclusive territories,
vertical price-fixing, licensing
----VFO is not necessary to meet those considerations!
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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 costs
Frequency: occasional or recurrent transactions
Uncertainty: demand and technological
Asset specificity: human, physical and/or site firmspecific investments
Dimensions of agency costs
Non-separability problems: asymmetry info. b/w
output and effort
Task programmability: knowledge of the
transformation process
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A Model of Governance Structure
Low Task Programmability
High Task Programmability
Low
Specificity
High
Specificity
Low
Specificity
High
Specificity
Low nonseparability
Spot
market 1
Long-term
contract 2
Spot
market
Joint
venture
High nonseparability
Relational
contract3
Clan
Inside
contract
4
5
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Hierarchy
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8
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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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