Vertical Integration, Appropriable Rents, and the Competitive Contracting Process
Klein, Crawford, and Alchian
Journal of Law and Economics, October 1978
Builds on Coase’s insight that transaction, coordinating, and contracting costs must be used to explain the degree of vertical integration. Thus if transaction costs are high, the firm will vertically integrate. This paper extends this by looking at “one particular [transaction] cost of using the market system–the possibility of post-contractual opportunistic behavior.” Where the costs of such post-contractual opportunistic behavior are high (e.g. when dealing with specialized processes and high fixed costs), vertical integration will supercede market systems.
Post-contractual opportunistic behavior (defined as unanticipated non-fulfillment of a contract) is particularly “bad” where an assets is specialized. That is where the value for a given use is much higher than the value of its next highest use. Several examples are given.
Publisher B buys printing services from Printer A for $5,500 a day. After getting a signed contract the printer goes and purchases the special press for which he would have little use and for which there is no active secondary market. It costs the printer $1500 a day to run the press (Variable Costs). Once the press is purchased, the publisher may now cut the payments from the $5500 a day to $1501 (since the purchase price is a sunk cost) and thus capture all the “quasi-rents” from the printer. Obviously the printer could sue for breach of contract but this involves costs and may not be successful. (Alternatively the publisher could claim VC such as maintenance had increased and raise his price)
The printer in the above example has market or “monopoly” power. In many circumstances each side has similar power.
These Bi-lateral monopolies create serious contracting problems/costs such as bonding and contingency planning. Thus to avoid these problems we can expect on firm to buy the other firm and internalize their operations.
It should also be noted that this post-contractual opportunistic behavior problem is lessened by reputation effects. Thus, long term contracts and agreements can lessen the problem.
Real world example of Fisher-Autobody and GM. In 1920s Fisher Autobody made car bodies for GM. GM was upset at the prices Fisher was charging and wanted a plant built adjacent to the GM plants. Fisher refused, GM eventually bought Fisher out. (Jim’s note: whether this happened or not is up for debate. See Coase)
Another example is an oil-pipeline owner. Once the wells are drilled the pipeline can decide to purchase the oil at a very low rate (just above the cost of getting it from the ground) and the well company can not do much about it. Each of the players here has a natural monopoly due to the entry costs (in the case of the pipeline) and land ownership (in the case of the well.)
The authors argue this has implications for unions since their reputation is more important than that of a single worker and they reduce the chance of opportunistic behavior in either direction. Raises the costs of cheating an employee and also prevents employee from reneging.
When dealing with specialized assets the post-contractual opportunistic behavior problem is more severe so there will be a greater degree of vertical integration.