The Costs and Benefits of

snowpeaschocolateManagement

Nov 18, 2013 (3 years and 11 months ago)

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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

Overview


Research Questions
: (1) What determines how vertically
or laterally integrated the activities of a firm are? (2)
A
re
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 2
nd

party, and this leads to
distortions


Opportunistic and distortionary behaviors are not
removed, only shifted


Purpose



(1) Present a theory of costly contracts


Contractual rights can be of two types: specific and
residual


Sometimes it is too costly to specify all rights over
assets


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
assets
(non
-
human: e.g., machines,
inventories)


Ownership = the purchase of residual rights of
control


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


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 contractible


Grossman 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
-
integration


Case 2: Firm 1 control


Case 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 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
investment