Proprietary and contractual vertical integration

Another proposed solution is the decision to integrate vertically. This decision presupposes the assessment of the transaction costs related to the operation performed through the contract or the proprietary integration. The choice to own assets should be evaluated in light of the comparison between the transaction costs of the unified governing rules and those associated with market contracting.¹⁰¹

In the early 1930s, the traditional literature considered the company to be a form of organization geared towards production. The primary justification for the vertical integration of production to another market level is the firm’s ability to promote economies of scale and product diversification. There would be no contraposition between the company and the contract.

According to classical economic theory, the contract would allow efficient results to be achieved.

In a seminal article from 1937, R. COASE raised a relevant question that changed this viewpoint.

The decision for vertical integration involves the strategic decision between performing a specific operation within the company and resorting to the market. This reflection extends to the present day through neo-institutionalism theory.¹⁰²

When resorting to the market (buy), the costs are inferior to the expenses of organizing an activity within the company (make). The latter is the alternative institution to the market. This is the choice between make and buy. The governance structure is an option to mediate a transaction more efficiently. Each choice has its qualities and imperfections, and there is an appropriate mechanism according to transactions’ attributes in order to achieve the lowest cost (or the highest gain).¹⁰³

The most pertinent governance structure can be the proprietary vertical integration of a transaction. Faced with the presence of hold-up risk, for example, after making specific

101 In the present work, the term “vertical integration” is widely used. It includes, in addition to the proprietary concentration, the long-term contractual relationship between subjects in the stages of the production chain (see A.

NICITA; V. SCOPPA, Economia dei Contratti, cit., p. 239).

102 Led by O. WILLIAMSON, The economic institutions of capitalism: firms, markets, relational contracting, cit., neo-institutionalism developed this idea. For this author, the decision to integrate vertically requires an assessment of the costs of a unified governing rules transaction and the costs associated with contracting in the market. For him, the optimal institutional choice of transaction governance must always take place in a second-best context. The underlying institutional problem is that of minimizing transaction costs.

103 A. NICITA; V. SCOPPA, Economia dei Contratti, cit., p. 23; P. JOSKOW, Asset Specificity and Vertical Integration, cit., p. 107.

investments, the protection can take the form of unified property vertical integration.¹⁰⁴ Proprietary integration allows the achievement of an efficient level of specific investments because it does not involve some costs associated with market contracting (for example, there is no staff training and no monitoring costs concerning the counterparty’s activity). The organization of a company also allows taking advantage of a provision entirely oriented towards its specific requirements. Any quantity or price-cost adjustments can be made immediately, without the parties having to renegotiate an agreement. There are no transaction costs in such a choice, nor is there a risk of opportunism. With these characteristics, the company choice is adequate for operators that seek to reduce the number of contingencies in their activity.¹⁰⁵

On the other hand, proprietary integration processes do not happen at zero cost; they entail the emergence of new transaction costs.¹⁰⁶ This implies increasing the costs of organizing the structure of the company, such as the cost of managing new productive units or supplying human capital. The lower productive specialization can reduce the quality of the product compared to that found in the market. Moreover, the market does imply necessarily high transaction costs and also has the advantage of labor specialization.

Despite the advantages of vertical integration within the firm, empirical evidence demonstrates frequent recourse to the market for a part of the company’s production process.¹⁰⁷ Examples include industrial subcontracting and outsourcing, partnership, comakership, franchising, business networking, and spot contracts. Known as alternative modes, or as hybrid or mixed forms of governance, they assume different structures according to the productive sector.¹⁰⁸ These contracts are not equivalent to the acquisition of the final product in the market.¹⁰⁹ They correspond to hybrid instruments, between contract and vertical integration, and such agreements

104 O. WILLIAMSON, The economic institutions of capitalism: firms, markets, relational contracting, cit.

105 A. RENDA, Esito di contrattazione e abuso di dipendenza economica: un orizzonte più sereno o la consueta “pie in the sky”, cit., p. 250 states that the choice to not outsource the production process, choosing the vertical integration within the company, allows it to enjoy a service completely oriented towards its specific requirements. The market represents a source of uncertainty, which might be unacceptable.

106 A. NICITA; V. SCOPPA, Economia dei Contratti, cit., p. 242.

107 A. RENDA, Esito di contrattazione e abuso di dipendenza economica: un orizzonte più sereno o la consueta “pie in the sky,” cit., p. 251.

108 P. JOSKOW, Asset Specificity and Vertical Integration, cit., p. 113 claims that empirical studies regarding vertical integration and how specific investments influence the choice of this mode of the governance structure. They show that such investments are statistics and economically critical causal factors that influence the decision for vertical integration.

109 A. RENDA, Esito di contrattazione e abuso di dipendenza economica: un orizzonte più sereno o la consueta “pie in the sky,” cit., p. 251.

aim to avoid the drawbacks of the ownership of the means of production (choice of make) and the limiting disadvantages and uncertainties of recourse to the market (choice of buy).¹¹⁰ In short, they seek the positive aspects of the choice of make and buy, though closer to the latter than the former.

An example of this choice is the Fisher Body and General Motors case. Next, the Grossman-Hart-Moore model shows some nuances in the decision to integrate vertically.

1.3.4.2.1. Fisher Body and General Motors case

Widely discussed in the economic literature, the Fisher Body (FB) and General Motors (GM) case illustrates the efficiency of ownership integration as a solution to the hold-up problem.¹¹¹ In 1919, GM completed a 10-year agreement with FB. GM undertook the acquisition of car bodies produced by that company. The fixed price was the cost borne by the supplier, plus a fixed percentage markup. The total cost could not exceed the price set for competitors of FB. The completion of a long-term contract, with exclusive supply to GM, served to protect the specific investments made by FB and against any changes in the market.

During the contract, GM’s demand for car bodies exceeded expectations. Given this situation, this company assessed the price adjustments as unsatisfactory. The contracted price did not consider the circumstance that the higher the demand for bodywork was, the more its price should decrease because it should reflect the economy of scale obtained by FB. Faced with this, GM asked FB to place its facilities close to its vehicle assembly line. In 1926, GM merged with FB.

In the traditional interpretation of the case,¹¹² there was excessive contractual rigidity in a long-term contract, which exposed it to uncertain and non-contractible ex-ante events. This contract configuration could induce further distractions in the economic choices of the contractors and prevent flexible forms from adapting. In this hypothesis, vertical integration could have solved the hold-up problem by ensuring greater efficiency concerning the long-term contract with rigid contractual clauses. The main lesson from this case is that the duration of the contract may be useful

110 Ibid., p. 251.

111 B. KLEIN; R. CRAWFORD; A. ALCHIAN, Vertical Integration, Appropriable Rents, and the Competitive Contracting Process, cit.

112 Ibidem.

in encouraging specific investments to be made in a short period, but at the same time, it reduces the degree of contractual flexibility necessary to allow its adaptation to new circumstances.¹¹³ This conclusion, based on the study by B. KLEIN, R. CRAWFORD, and A. ALCHIAN, has been the object of recent criticism. Some authors believed that the case is an example of market failure in contract literature and company theory.¹¹⁴ In addition, allegedly, there were controversial and unexplained questions. For example, at the moment of proprietary integration, GM was already in possession of about 60% of FB’s capital stock. The acquisition could allow GM to exercise control over FB. The explanation for acquiring the rest of the capital would be that GM sought to control not the company, but the human capital of the Fisher brothers, experts in the car body, and remove them from the competition.

1.3.4.2.2. The Grossman-Hart-Moore model

The work of S. GROSSMAN and O. HART (1986)¹¹⁵ and O. HART and J. MOORE (1990)¹¹⁶ presents nuances concerning the decision to carry out vertical integration. The authors’ work, known as the Grossman-Hart-Moore model (GHM model), is based on the difference between two modalities of contractual rights, specific rights and residual rights, to explain the scenarios in which vertical integration entails benefits. Faced with the cost of specifying asset rights in a contract, the party should acquire all residual rights through vertical integration to reach the socially optimal measure.¹¹⁷

113 A. NICITA; V. SCOPPA, Economia dei Contratti, cit., pp. 244-5.

114 R. CASADESUS-MASANEL; D. SPULBER, The Fable of Fisher Body, in Journal of Law & Economics, vol. 43, no. 1, April, 2000.

115 S. GROSSMAN; O. HART, The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration, in Journal of Political Economy, August 1986, vol. 94, no. 4.

116 O. HART, Oliver; J. MOORE, Property Rights and the Nature of the Firm, in Journal of Political Economy, vol. 98, no. 6, Dec., 1990.

117 It is necessary to summarize the reasoning of these works. The authors argue that existing theories of vertical integration are not able to explain the definition of integration, nor the costs and benefits to be assessed. These theories would identify vertical integration as able to provide results similar to those of a complete contract. The authors define integration regarding rights over assets and develop a model to explain when a company must acquire the assets of another firm, thus promoting a vertical integration. The authors define the company as the assets it owns or over which it has control. In the authors’ view, there is no distinction between control and ownership. For example, the corporation shareholders are the group that owns the control and delegates it to the board of directors. The distinction proposed by the authors, between contractual rights and residual rights, arises from this perspective. The difference between vertical integration and contracting would be the control of rights not specified in the contract (residual rights). The owner controls all aspects not specified in the contract, whereas the contractor would only have control over the specific rights. The authors conclude that the optimal decision for the parties would be to acquire control of an asset, as it is very costly for a party to specify a long list of rights. The analysis should not be between complete contracts and

The GHM model shows how the allocation of ownership rights over assets used in the production process can contribute to minimizing underinvestment due to contractual incompleteness. The model proposes an explanation of the efficient allocation of property rights when more than one agent is involved in making specific investments and competes for the control of resources. In order to maximize the aggregate efficiency and achieve the maximum possible surplus, the issue is to determine the ownership of capital goods according to the individual with the most significant capacity to achieve the objectives.¹¹⁸

The results of this theory have been applied to the notion of the modern enterprise to propose a theory of organization and control, as well as situations of incomplete contract between a company and a financier. Some corporate governance proposals are also based on access to property rights and control of the company by individuals with the most specific human capital to manage it.¹¹⁹