Tuesday, 6 August 2013

The why (or why not) of vertical integration

At the Latent Paradigm blog Seth Goldin asks Why would a firm choose vertical integration? Part of Goldin's answer reads,
Why would a profit-maximizing firm choose vertical integration? Recall from Coase that firms exist to minimize transaction costs. If transaction costs between lessors and lessees are high enough, vertical integration is attractive. According to the widely cited 1978 paper by Benjamin Klein, Robert G. Crawford, and Armen A. Alchian, we might see vertical integration from a specific kind of transaction cost: post-contractual opportunistic behavior. A production technology with high fixed costs that cannot be recovered by being scrapped into alternative uses will tend to be vertically integrated into the rest of the product’s production process. What are some implications of this? The paper explains:
  • Fisher Body once supplied specialized metal dies that would stamp entire automobile bodies for General Motors. Fisher repeatedly tried to extract monopoly rents from GM, but eventually, in 1926, the companies merged.
  • Oil refineries are usually vertically integrated with oil pipelines, but not with oil tankers. An independent oil refinery would be hostage to a monopsonistic pipeline lessor, but an oil tanker has a potential appropriable rent near zero, because an oil tanker could easily be repurposed for shipping other goods.
  • Owners of highly perishable crops are quite vulnerable to collective demands by their laborers. Slavery was a form of vertical integration, but now, absent slavery, long-term labor contracts with unions consist of rigid wages with layoff provisions so that employers can’t opportunistically claim false reductions in demand.
  • Franchise relationships mimic vertical integration because, although a franchisee is technically an independent firm, the franchisee is essentially renting a brand, and is subject to certain controls by the franchisor.
  • Specific capital investments that have high fixed costs and can’t be easily repurposed could be subject to opportunistic behavior by workers, so the owners of firms tend to own specialized capital investments. Owners of firms use detailed employment contracts to prevent the appropriation of specialized capital by their employees. Such detailed employment contracts mimic the function of vertical integration.
The interesting point about the Klein, Crawford and Alchain argument is that Coase rejects it! As Klein himself  summarised the situation,
I have always considered my work with Armen Alchian and Robert Crawford (1978) on vertical integration to represent an extension of Coase's classic article on "The Nature of the Firm." By focusing on the "hold-up" potential that is created when firm-specific investments are made by transactors, or what we called the appropriation of quasi-rents, I believed we had elucidated one aspect of the Coasian concept of transaction costs associated with market exchange. We hypothesized that an increase in firm-specific investments, by increasing the market transaction costs associated with a hold-up, increased the likelihood of vertical integration. This relationship between firm-specific investments, market transaction costs, and vertical integration was illustrated by examining the contractual difficulties that existed when General Motors purchased automobile bodies from Fisher Body and the corresponding benefits that were created when the parties vertically integrated.

It is clear from Coase's lectures that he considers our analysis not to represent an extension of his earlier work, but rather to be an alternative, incorrect explanation for vertical integration (1988: lecture 3). Coase recognizes that an increase in the quasi-rents yielded by firm-specific investments creates a hold-up potential. However, he argues that there is no reason to believe that this situation is more likely to lead to vertical integration than to a long-term contract. Although long-term contracts are imperfect, opportunistic behavior is usually effectively handled in the marketplace, according to Coase, by a firm's need to take account of the effect of its actions on future business. Coase claims that before writing his classic paper he explicitly considered opportunistic behavior as a motive for vertical integration, in particular as it applied to the General Motors-Fisher Body case, and explicitly rejected it.
The Klein, Crawford and Alchain paper has also lend to the soap opera that is the literature on the General Motors-Fisher Body integration. Some people claim hold-up drove the GM takeover of Fisher Body, some say there was no hold-up at all while others say there was hold-up by the Fisher brothers, but only after the takeover by GM and yet others blame the lawyers!

Read Baird (2003), Casadesus-Masanell and Spulber (2000), Coase (2000), Coase (2006), Freeland (2000), Goldberg (2008), Klein (1988), Klein (1996), Klein (2000), Klein (2007), Klein (2008) and Klein, Crawford and Alchian (1978) ... and then decide.

In short vertical integration is complicated. Modern organisational economics offers diverse theories of the boundaries of firms (i.e. theories of vertical integration). Such theories are based around various frictions or transaction costs; Knightian uncertainty, imperfect foresight or bounded rationality, small-numbers bargaining, haggling costs, private information, cost of processing information, costs of inspecting quality or imperfect legal enforcement. Given such costs internalising activities within a firm may be more efficient than relying on market transactions.

(HT: Knowledge Problem.)

  • Baird, Douglas G. (2003). ‘In Coase’s Footsteps’, John M. Olin Law & Economics Working Paper No. 175 (2d series), The Law School The University Of Chicago, January.
  • Casadesus-Masanell, Ramon and Daniel F. Spulber (2000). ‘The Fable of Fisher Body’, Journal of Law and Economics, 43(1) April: 67-104.
  • Coase, Ronald Harry (2000). ‘The Acquisition of Fisher Body by General Motors’, Journal of Law and Economics, 43(1) April: 15-31.
  • Coase, Ronald Harry (2006). ‘The Conduct of Economics: The Example of Fisher Body and General Motors’, Journal of Economics & Management Strategy, 15(2) Summer: 255-278.
  • Freeland, Robert F. (2000). ‘Creating Holdup Through Vertical Integration: Fisher Body Revisited’, Journal of Law and Economics, 43(1) April: 33-66.
  • Goldberg, Victor P. (2008). ‘Lawyers asleep at the wheel? The GM-Fisher Body contract’, Industrial and Corporate Change, 17(5): 1071-84.
  • Klein, Benjamin (1988). ‘Vertical Integration as Organizational Ownership: The Fisher Body-General Motors Relationship Revisited’, Journal of Law, Economics, and Organization, 4(1) Spring: 199-213.
  • Klein, Benjamin (1996). ‘Why Hold-Ups Occur: The Self-Enforcing Range of Contractual Relationships’, Economic Inquiry, XXXIV, July: 444-63.
  • Klein, Benjamin (2000). ‘Fisher-General Motors and the Nature of the Firm’, Journal of Law and Economics, 43(1) April: 105-41.
  • Klein, Benjamin (2007). ‘The Economic Lessons of Fisher Body-General Motors’, International Journal of the Economics of Business, 14(1) February: 1-36.
  • Klein, Benjamin (2008). ‘The enforceability of the GM-Fisher Body contract: comment on Goldberg’, Industrial and Corporate Change, 17(5): 1085-96.
  • Klein, Benjamin, Robert G. Crawford and Armen A. Alchian (1978). ‘Vertical Integration, Appropriable Rents, and the Competitive Contracting Process’, Journal of Law and Economics, 21(2) October: 297-326.

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