Opportunism in Vertical Integration and Appropriable Rents

VERTICAL INTEGRATION, APPROPRIABLE RENTS, AND THE COMPETITIVE CONTRACTING PROCESS B. Klein, R. Crawford, & A. Alchian 1978, JLE

PAPER OVERVIEW A Key Question A Key Question: Given the theories presented in Coase (1937), what possibilities for post-contractual opportunistic behavior exist and how can they be dealt with? What is Opportunistic Behavior ? What is Opportunistic Behavior ? Unanticipated non-fulfillment of a contract or agreement When some party A reneges in some form on some agreement with some party B

OPPORTUNISM AND RENTS Opportunism occurs in the form of appropriation of quasi-rents Specifically, after an investment is made, the presence of appropriable quasi-rents leads to the risk of opportunism What are Quasi-rents ? The value of an asset above the next best use What are Appropriable Quasi-rents (AQR)? The portion of quasi-rents in excess of an assets value to the next highest-valuing user

EXAMPLES OF QUASI-RENTS Party B pays Party A $5,500 to use some equipment Party C will pay Party A $3,500 to use the same equipment Party A incurs $1,500 maintenance cost for the equipment Party A could salvage the equipment for $1,000 Quasi-rents = Revenue Maintenance Salvage = $5,500 - $1,500 - $1,000 = $3,000 AQR = Rate of Party B Rate of Party C = $5,500 - $3,500 = $2,000

DEALING WITH OPPORTUNISM Vertical Integration Examples Paper company owns forest, paper mill, and retail stores Newspaper publisher typically own their printing press, but book publishers do not; WHY? Economically Enforceable Long-term Contracts Explicitly enforceable by an outside institution (i.e. government) Solutions can by prohibitively costly Implicitly enforced by market mechanisms (i.e., higher future rates) Effective under specific situations Self-enforcing agreements

EXAMPLES OF APPROPRIABLE QUASI RENT 1. 1. AUTOMOBILE MANUFACTURING AUTOMOBILE MANUFACTURING 1919 GM and Fisher Body entered into 10 year contractual agreement for the supply of closed auto bodies (GM agreed to buy all bodies from Fisher) Price of bodies were set at 17.6% + production cost and price charged could not exceed what Fisher charges other manufacturers nor greater than the average market price of similar bodies produced by others. 1924 65% of GM s automobiles were of closed body type (all of which came from Fisher Body) GM very unhappy. Fisher also refuses to relocate its plant near the GM assembly plant (mobility cost too high). 1926 Vertical merger between Fisher Body and GM. 6

EXAMPLES OF APPROPRIABLE QUASI RENT 2. PETROLEUM INDUSTRY 2. PETROLEUM INDUSTRY A s OIL WELL A s OIL WELL Installed Installed oil B B + + Refinery Refinery installation specialized specialized to to C s specificity) specificity). . oil producing producing equipment installation of of D D and C s pipe pipe line equipment of of A A and and E E are line (very (very high high asset and are asset B B s OIL WELL s OIL WELL The The portion portion of of their the the next next best quasi quasi rent rent. . their value value above best user user becomes above the becomes appropriable appropriable the value value to to Pipeline Pipeline owner owner C C could could potentially potentially . . D s REFINERY D s REFINERY E E s REFINERY s REFINERY a. a. Purchase Purchase oil extracting extracting oil b. b. Sell Sell the the oil of of alternative alternative sources refineries refineries (e (e. .g g. ., , train) train) oil at at marginal oil oil to to the the refineries refineries to to the sources of of supply marginal cost cost of of the price price supply to to 7

EXAMPLES OF APPROPRIABLE QUASI RENT 2. PETROLEUM INDUSTRY 2. PETROLEUM INDUSTRY A s OIL WELL A s OIL WELL B B s OIL WELL s OIL WELL Therefore Therefore.. .. A, A, B, B, D D and company company which and E E forms which owns owns the forms a a jointly the pipeline jointly owned pipeline. . owned JOINTLY OWNED JOINTLY OWNED e e. .g g. ., , Rockefeller Rockefeller obtained from from railroad railroad companies threatening threatening to to build appropriated appropriated quasi companies companies. . obtained price companies (that build a a pipeline quasi rents rents from price reduction reduction (that ship ship oil) pipeline. . He from the the railroad oil) by by He D s REFINERY D s REFINERY E E s REFINERY s REFINERY railroad

INTEGRATION OR CONTRACT? All other things equal, the lower the appropriable specialized quasi-rents, the more likely the transaction parties will rely on contractual relationships rather than common ownership If an asset offers a substantial portion of quasi-rent, which is strongly dependent upon some other particular asset, both assets will tend to be owned by one party.

FINAL THOUGHTS What kind of assets have quasi-rents? Almost anything physical assets, human capital, social constructs, etc. Kessler and Stern (1959) argue that long-term contracts are a form of vertical integration What continuum exists here? What major thresholds occur between integration and contracting? The issues surrounding ownership relationships and efficiency quickly become complex and difficult to predict