Investment specificity, ex-ante incentives to invest, incomplete contracts, vertical integration

This is originally posted on Wednesday, 30 January 2013 at 22:05

2009 ZA 1, 2009 ZB 1

Analyze how investment specificity affects the ex-ante incentives for investment and the incompleteness of contracts may affect the decision of a firm to vertically integrate and discuss briefly any relevant empirical evidence.

Although a firm may sell a certain product in the market, it may not have all the necessary inputs (raw materials or intermediate goods) within itself. Hence the firm needs to search for ways to purchase the necessary inputs. The firm is therefore a Buyer of the input, and its counterparty the Supplier. 

When a Buyer establishes a relationship with a Supplier, they will negotiate for the distribution of ex-post surplus. This negotiation may be formalized in a contract, and takes place ex-ante before the Supplier produces the necessary inputs and delivers them to the Buyer.   

The total size of the ex-post surplus can be increased if either parties undertakes sunk cost investments in assets which specifically improves the profitability of the final product sold to consumers. These assets are relationship-specific, in the sense that they are tailored exclusively for the relationship between the Buyer and the Supplier. For example, an automobile manufacturer named Parkerine may purchase engine parts from the Supplier. The engine parts are incompatible with the production process of any other automobile manufacturer. The equipment used to produce Parkerine engine parts are specific to the relationship between Parkerine and its Supplier. Generally, assets with such properties are known as Relationship-Specific Assets. 

Investment specificity affects ex-ante incentives for investment because it increases the switching costs for the party who undertakes such investments in a trading relationship. The sunk costs of investing in such assets, coupled with the inability for such relationship-specific assets to yield as much surplus outside the existing relationship, causes the investing party to be "locked in" the relatonship. 

This creates a "holdup problem" due to the opportunistic behavior of the non-investing party, who is able to renegotiate their contract once the production and sales of the final product are completed. The investing party has weaker bargaining power since it is more likely to incur a loss if it abandons the relationship. The non-investing party will take advantage and appropriate a disproportionately large portion of the ex-post surplus even though it did not bear  the cost of ex-ante investments. 

The investing party may therefore respond to potential holdups by intentionally reducing its ex-ante investments in relationship-specific assets, dampening its exposure to opportunistic behavior. Alternatively it may substitute relationship-specific assets with more general production methods. As general production technologies tend to be less efficient, there will be a reduction in gains from trade. 

The problems from investing in relationship-specific assets arise because holdup eliminates residual claimancy status- the investing party do not capture all the gains from investing in the relationship-specific assets. 

Contracts are supposed to govern the trading relationship to ensure the ex-ante agreement to distribute ex-post surplus is honored. However, the incompleteness of contracts (due to transaction costs) leads to ambiguities which distort incentives and allows the perpetuation of opportunistic behavior, which leads to certain ineffiencies.

Firms incur transaction costs from writing and enforcing complex contracts in anticipation of potential holdups. In addition, firms have the incentive to renegotiate the terms of exchange- delays due to renegotiation when there is temporal specificity will add on to the costs of contracting. In additon, the failure to renegotiate and realize efficient adaptation will result in unrealized gains from trade. 

While some firms expend resources to elicit concessions, their trading partners may expend resources to prevent holdups. Buyers often practice "second sourcing"- they incur additional expediture to reduce dependency and avoid being locked in to a single supplier. This improves their ex-post bargaining power but it may mean a loss of economies of scale, resulting in a decrease in productive efficiency. Productive resources are diverted to activities that increase private value (redistribution of ex-post surplus) but no social value (nothing is produced).

The inefficiencies of the holdup problem cannot be solved by contracts (which are never perfectly complete). If the inefficiencies of incomplete contracts are sufficiently large, the firm may considering internalizing the transaction. When a Buyer vertically integrates with a Supplier, it is able to acquire in-house the necessary input for production. There is no need to contract with an independent supplier anymore. Under vertical integration, the Buyer becomes the Production division within the firm. Residual control rights will be alllocated to either party, who will claim ownership over their combined assets. 

Vertical integration is purported to be a different form of governance from contractual parties under the price system. It resolves the holdup problem by imposing legal obligations, internalizing dispute resolution and improving access to information about exogeneous changes and actions of the trading parties. 

When firms vertically integrate, one party will be transformed from the identity of an independent contractor to an employee of the other party. Employees, unlike independent contractors, have the legal obligation to obey the direction of management, disclose information within the firm and act in the interests of their employer. Fundamentally, the different parties now belong to the same firm, sharing the common objective of joint profit maximization. 

Contractual disputes are often settled by bargaining between the trading parties (in which opportunistic behavior and its associated inefficiencies arise). Alternatively, they can settle the dispute via a third party- the legal court or an independent arbitrator. In a vertically integrated firm, the disputes between divisions- Production and Supplier- are settled by top management. 

Dispute resolution relating to holdup problems tend to be more efficiently internally because of the less formal nature of the mechanism (court proceedings versus internal meetings) allows for flexibility and reduces the costs associated with renegotiation and complex contracts.

In addition, management is more likely to possess the background and expertise to understand and resolve the dispute efficiently. The managment is able to obtain accurate information at lower costs than a third party or an independent contractor. The management is therefore an effective intermediary which gathers and "publicizes" (within the firm) the information about exogeneous changes and actions of the trading parties. Information assymetry between the Production division (Buyer) and the Supplier will be minimized, reducing the scope for opportunistic behavior between the two parties. 

Grossman and Hart (1986) however felt that vertical integration does not change the nature of governance, but it does change ownership and therefore the allocation of residual control rights. Their approach highlights the possibility vertical integration may not always be the optimal decision- in certain cases, vertical seperation may be the optimal outcome for both parties, if the investments are not relationship-specific.  

Klein, Crawford and Alchian (1987) showed that asset specificities led to the vertical integration of General Motors and Fisher Body. In 1919, General Motors entered into a long-term contract with Fisher Body for the supply of closed-metal autobodies. This "locked in" General Motors to the trading relationship. However the contract was incomplete- it failed to anticipate a major shift in demand from wooden autobodies to closed-metal autobodies in the automobile industry. 

By 1924, General Motors became dissatisfied with the pricing provisions in the contract. It believed that prices could have been lower if Fisher Body invests in new production technologies which can replace the relatively inefficient and labor intensive production process. In addition, Fisher Body refused to accede to General Motor's request to locate its plant next to General Motors' assembly facilities, which will reduce transportation costs and the price charged by Fisher Body. 

The actions of Fisher Body could be understood in light of the above discussion- Fisher Body intentionally underinvests in relationship-specific assets, preferring to substitute it for more general forms of production. In addition, it seeks to avoid site specificity by not locating closer to General Motors. These actions are taken to minimize its exposure to opportunistic behavior of General Motors. In addition, the long-term contract locks in General Motors, allowing Fisher Body more bargaining power to hold up General Motors. 

In 1924, General Motors began acquiring stock in Fisher Body and by 1926, the takeover was complete. General Motors carried out a downstream integration with Fisher Body, and it acquired ownership and residual control rights to the integrated entity. Vertical integration enabled General Motors to locate its autobody supplier next to its assembly plant and adopt more capital intensive, cost-efficient production for its closed-metal autobodies. 

2008 ZA 1, 2004 ZA 1, 2004 ZB 1 (incomplete)

Describe the transaction cost-property rights approach to the theory of the firm, including a careful examination of the key elements of this approach and discussion of the basic theoretical predictions. What is the empirical support for this approach?

The transaction cost-property rights approach starts by examining the firm's choice of organizing economic activities which forms a part of its overall production process. The firm could either conduct economic activities internally (in-house) or obtain the function externally (purchasing from spot markets or contracting with other independent firms). The firm's choice is determined by the costs and benefits associated with each mode of economic organization. 

All firms require some form of input to provide their goods and services. The inputs may come in the form of raw materials or intermediate goods/services. If the firm has an internal division which provides such inputs, it has no need to engage externally. However if the input is not provided in-house, the firm needs to turn to spot markets to purchase such inputs.

In the spot market, inputs are sold by independent firms at the prevailing market price. This allows for efficient adaptation and cost minimization for both the Buyers and Suppliers of the input. However the advantage of spot markets are mitigated by the existence of switching costs. Switching costs prevent firms from costlessly terminating and forming new trading relationships in the spot market. In fact, when switching cost outweighs the benefit of forming a new trading relationship, the Buyer and Seller will remain "locked in" to their relationship. As the "locked in" relationship evolves, it will be subjected to either unconstrained bargaining, contractual arrangement or vertical integration.

Switching costs are costs incurred by firms when there is a switch of trading relationships (ie. one party terminates the current arrangement to trade with a new party). Coase (1988) argues that switching costs include the cost of searching for a new trading partner and the costs associated with renegotiating a new arrangement. In addition, Williamson (1975) argues that investment specificity give rise to switching costs 

When a Buyer establishes a relationship with a Supplier, the total size of their ex-post surplus (total gains from trade) can be increased if either parties invest in relationship-specific assets (investment specificity). These assets are relationship-specific, in the sense that they are tailored exclusively for the relationship between the Buyer and the Supplier. Relationship-specific assets have limited value or usage if parties in the trading relationship changes. The relationship-specific asset's productivity may be lower, or additional costs have to be incurred if it is redeployed to a new trading relationship. The investment costs are also sunk- the amount invested cannot be recovered if the investing party terminates the trading relationship. 

Williamson identifies a few types of investment specificity: physical asset specificity (production equipment of inputs are tailored to the needs of the Buyer), site specificity (investments in productive assets are made in close geographic proximity to one another) and human asset specificity (technical expertise and accumulated knowledge dedicated to the production of specific inputs). Masten (1996) identifies temporal-specificity, which exists when the "time is of essence". These include perishables (eg. vegetables), serial production (eg. construction), goods and services whose value are dependent on timing (eg. newspapers) and products which are impossible or costly to store (eg. natural gas). In addition, there exist "dedicated assets" which are not relationship-specific. However if the Buyer chooses to reduce or terminate its purchase, the Supplier will have substantial excess capacity. 

The sunk costs of investing in relationship-specific assets, along with the potential surplus forfeited when the investing party terminates the current relationship implies that switching costs exist even prior to the termination of the trading relationship. The investing party is locked in to the relationship, exposed to the opportunistic behavior of its trading partner.

The Coase Theorem (in its general form) states that in the absence of transaction costs, all parties involved will bargain to an efficient outcome irregardless of the initial allocation of property rights. If there are no transaction costs involved in writing a contract, it is possible to write a contract which accounts and makes provisions for every contingency. The complete contract will never face a scenario where its terms are subjected to ambiguity or need to be amended. However the transaction costs of writing a contract, including costs incurred to tackle complexity, monitoring of the parties involved and enforcement of the terms of the contract ensures that there in reality it is rarely possible to write a complete contract.

The ambiguities of the incomplete contract are subjected to unconstrained bargaining and opportunistic behavior which leads to the holdup problem. 

Due to the holdup problem, there is a tendency to underinvest in relationship-specific assets.