The Costs and Benefits of


18 Νοε 2013 (πριν από 4 χρόνια και 7 μήνες)

82 εμφανίσεις

The Costs and Benefits of
Ownership: A Theory of Vertical and
Lateral Integration

Oliver D. Hart, Professor
of Economics at Harvard

Sanford J. Grossman,
Chairman and CEO of QFS
Asset Management

Slides prepared by Jenna Moore,
BADM 545


Research Questions
: (1) What determines how vertically
or laterally integrated the activities of a firm are? (2)
there costs and benefits associated with ownership?

Conventional wisdom
: incomplete contracts

integrated relationship

inferior outcomes (compared
to complete contracts)

transactions cost
based theory (e.g.,
, 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


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 2

party, and this leads to

Opportunistic and distortionary behaviors are not
removed, only shifted


(1) Present a theory of costly contracts

Contractual rights can be of two types: specific and

Sometimes it is too costly to specify all rights over

Alternative: 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
human: e.g., machines,

Ownership = the purchase of residual rights of

Because contracts are incomplete, the
ex post

allocation of power (or control) matters

What are the costs and benefits of integration?
Grossman & Hart present a model


Presented a formal model of relationship between 2

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 contractible

Grossman and Hart present the model in detail, and
then apply results to a firm in insurance industry



(1) all variables are ex ante non

(2) investments by managers 1 and 2 are
chosen simultaneously and non

(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

Case 2: Firm 1 control

Case 3: Firm 2 control

Determining distortions associated
with different ownership structures


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
investment by firm 1 is less severe problem than
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

Application of theory to insurance

Grossman & Hart use their framework to
analyze the determinants of who owns the list
of policyholders (i.e., the only asset in this

They illustrate that the trade
offs between
different ownership structures are the same as
in their formal model


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

Integration only shifts incentives for opportunistic and
distortionary behaviors

Their 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