15 April 2008

Vertical mergers and the nature of the firm (part 1)

What are the benefits of vertical integration? To understand why firms sometimes vertically merge, we need to look at two issues: (i) contractual relations between upstream and downstream firms, and (ii) the mechanics of decision-making within a vertically integrated firm. In particular, we need to consider why there may be obstacles to efficient contracting in the absence of integration, and in what areas of decision-making these obstacles are likely to arise. We also need to consider how control over business decisions is reallocated following vertical merger. These questions are linked to work on the nature and boundaries of the firm.

Contractual limitations and the nature of the firm

A firm may be defined as the basic unit for organising production, which performs the crucial role of linking labour and product markets. Reasons why the supply of the products of labour tends to become organised in this way include specialisation, economies of scale, economies of scope and the reduction of search costs. These reasons also indicate what the firm consists of, beyond an abstract point of trade between workers and consumers. The reduction of search costs, for example, is achieved by means of the firm’s reputation and location, one of a class of intangible assets belonging to the firm, which may also include the names of its products ('brands') and other forms of goodwill.

Since the production of goods or services typically uses tangible assets in addition to labour, the firm will also have access to assets used in production. These may include the premises where work takes place, and/or where trade is carried on with consumers. Search costs arising from information asymmetries relate not only to the interaction between workers and consumers, but also to the interaction between different types of worker, once specialisation of function comes into play within a single firm. This suggests that another ‘asset’ which the firm controls is the organisational structure which makes the necessary co-ordination possible.

The work of Sanford Grossman, Oliver Hart and John Moore has helped to confirm this identification of the firm with control over business assets. The assets in question may be assets required for production or, more abstractly, intangibles such as goodwill without which workers would find it difficult to trade with consumers. Specifically, control over assets is identified with ‘residual decision rights’ — those rights which have not been explicitly contracted away. Grossman and Hart (1986) point out that

control or ownership is never absolute. For example a firm that owns a machine may not be able to sell it without the permission of the lenders for which the machine serves as collateral; more generally, a firm may give another firm specific authority over its machines. However, ownership gives the owner all rights to use the machine that he has not voluntarily given away or that the government or some other party has not taken by force. (p.694)

The crucial characteristic which distinguishes the firm’s workers from external parties with whom the firm contracts for supplementary inputs is the dependence of workers on the firm’s assets, rather than their legal relations with the firm. Thus workers who are notionally self-employed may be de facto employees if they need to employ assets over which the firm has control. The relationship between a firm’s control over assets and its control over workers is explained further in Hart and Moore (1990).

We suppose that the sole right possessed by the owner of an asset is his ability to exclude others from the use of that asset. ... [C]ontrol over a physical asset in this sense can lead indirectly to control over human assets. For example, if a group of workers requires the use of an asset to be productive, then the fact that the owner, party 1 say, has the power to exclude some or all of these workers from the asset later on (i.e. he can fire them selectively) will cause the workers to act partially in party 1’s interest. (p.1121)

Reasons why vertical separation may be suboptimal

Say that vertical separation can under certain circumstances lead to suboptimal outcomes. We need to ask why it is not possible for firms to to use contracts rather than merger to eliminate these inefficiencies. First, consider the question of production decisions. It has been argued that these may be sufficiently complex such that they cannot be specified completely ex ante.

[It] may be difficult, if not impossible, to describe precisely the input characteristics required in the future even though these characteristics might be easily described ex post. If a contract for future delivery only vaguely describes the characteristics of the good to be delivered, the supplier may have strong incentives ex post to deliver an ineffective input. Then, despite the presence of the contract, the parties will essentially be left to bargain over the procurement of the input that is really needed. For instance, IBM may not be capable of describing what sort of microchip it wants Intel to deliver five years from now for a computer that it is currently developing, even though in due time it will be able to describe its needs precisely. In this case, IBM may not gain much from writing a long-term future delivery contract with Intel. (Bolton and Whinston 1993, p.127)

Secondly, it has been argued that cost and income streams cannot necessarily be transferred by contract because of the difficulties of verifying such streams. Hart and Tirole (1990) point to the weakness of any agreement which attempts to contract away all or part of an owner’s return stream, such as a compensation package for a manager based on observed profits, or other types of profit-sharing.

Profit-sharing may be difficult to implement in the absence of integration ... because independent units can divert money and misrepresent profits. ... [C]onsider an independent unit, A, that has signed a profit-sharing agreement with firm B. One way A can misrepresent and divert its profits is by purchasing an input at an inflated price from another company in which A’s owners have an interest. It may be hard for B to write an enforceable contract ex ante to prevent such a diversion, even though B may be well aware of the practice ex post (the information that the input is overpriced is observable but not verifiable). On the other hand, if A and B are integrated, B can refuse ex post A’s manager’s request to spend company resources on the expensive input, thus effectively blocking the transaction. This is because B now possesses residual rights of control over company A’s resources by virtue of integration. (pp.206-207)

These points help explain why there may be advantages to vertical integration which cannot be duplicated even by sufficiently complex contracts between separated upstream and downstream firms. The next post will look in greater detail at the internal mechanics of an integrated firm, and consider whether similar limitations may affect relations between upstream and downstream units even after a merger has taken place.

Bolton, P. and Whinston, M. (1993), ‘Incomplete contracts, vertical integration, and supply assurance’, Review of Economic Studies, 60, 121-148.
Grossman, S. and Hart, O. (1986), ‘The costs and benefits of ownership: A theory of vertical and lateral integration’, Journal of Political Economy, 94, 691-719.
Hart, O. and Moore, J. (1990), ‘Property rights and the nature of the firm’, Journal of Political Economy, 98, 1119-1158.
Hart, O. and Tirole, J. (1990), ‘Vertical integration and market foreclosure’, Brookings Papers on Economic Activity (Special Issue), 205-276.