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Grossman Hart 86

Grossman Hart 86

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The Costs and Benefits of Ownership: A Theory of Vertical and Lateral IntegrationAuthor(s): Sanford J. Grossman and Oliver D. HartReviewed work(s):Source:
Journal of Political Economy,
Vol. 94, No. 4 (Aug., 1986), pp. 691-719Published by:
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The Costs andBenefits ofOwnership:ATheory ofVertical andLateral IntegrationSanford J.Grossman
PrincetonUniversity
Oliver D.Hart
Massachusetts nstitute of Technology
Ourtheoryofcostlycontracts emphasizes that contractual rights canbeof two types: specificrights and residualrights. When it is costly tolist all specific rights overassets in the contract,it may be optimal toletone party purchase allresidual rights.Ownership is the purchaseofthese residual rights.When residual rightsare purchased by oneparty,they are lost by asecond party, andthis inevitably createsdistortions.Firm1purchases firm 2 when firml's control increasestheproductivity of itsmanagement more than the loss of controldecreases theproductivity of firm 2'smanagement.I.Introduction
A.GeneralIntroduction
Whatis a firm?What are thedeterminants ofhowverticallyorlater-allyintegratedtheactivitiesofthefirmare? Thispaperbuilds on thefoundations laidby Coase(1937), Klein,Crawford,andAlchian(1978), and Williamson(1979), whichemphasize the benefits of"con-
Research wassupported bytheNational ScienceFoundation,the AlfredP.SloanFoundation,and the International Centrefor Economicsand RelatedDisciplinesattheLondonSchoolofEconomics.Thisis anextensivelyrevisedversionof an earlierpaper(Grossmanand Hart1984).Wegratefully acknowledgehelpfulcomments fromDebraAron, PeterDiamond,RichardEpstein,NaavaGrossman,PaulJoskow, JohnMinahan,JimPoterba,AndrewPostlewaite,PeterThistle,MartinWeitzman,OliverWilliamson,CharlesWilson,ToniZabalza,and two referees.
[JournalofPoliticalEconomy,1986,vol.94,no.4]?1986byTheUniversityofChicago.Allrightsreserved.0022-3808/86/9404-0004$01.50
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JOURNAL OF POLITICAL ECONOMY
trol" in responseto situations in whichthere are difficultiesin writingor enforcing completecontracts (see alsoWilliamson1971,1983; Wil-liamson, Wachter,and Harris 1975;Teece 1980). We definethe firmasbeing composedof the assets (e.g.,machines, inventories)that itowns. We presenta theory of costlycontracts that emphasizesthatcontractual rightscan be of two types:specific rights andresidualrights. When it istoo costly for oneparty to specify a longlist of theparticular rightsit desires over anotherparty's assets, itmay be op-timal for that partyto purchase all therights except thosespecificallymentioned in thecontract. Ownershipis the purchase ofthese resid-ual rights of control.We show that therecan be harmfuleffects asso-ciated with thewrong allocation ofresidual rights. In particular,afirm that purchasesits supplier, therebyremoving residualrights ofcontrol from themanager of the supplyingcompany, candistort themanager's incentivessufficiently tomake common ownershipharm-ful.We developa theory of integrationbased on the attemptof par-tiesinwriting acontract to allocateefficiently the residualrights ofcontrol betweenthemselves.Webegin byreviewingsometransactionscost-basedargumentsforintegration. Coase(1937) suggestedthat transactions willbe orga-nized in the firmwhen the cost of doingthis is lower thanthe cost ofusing the market.He added some contentto this idea byproposingthat the costs ofconstant recontractingwith an outsidefirm or man-agercanbe highrelative to those ofsigning a long-termcontractwithanemployeeinwhich the employeeagrees to carryout thecommandsof theemployer.Klein et al. (1978)and Williamson(1979)addedfurther contentby arguing that a contractualrelationshipbetween aseparatelyowned buyer and sellerwill beplagued byopportunisticandinefficient behaviorin situationsin which there arelargeamountsofsurplustobe dividedexpostandinwhich,becauseoftheimpossi-bility of writinga complete, contingentcontract,theexante contractdoes notspecifya clear divisionof thissurplus.Suchsituationsin turnarelikelytoarisewhen eitherthebuyerorsellermust makeinvest-mentsthat havea smaller valueinause outsidetheir ownrelationshipthan within the relationship (i.e.,there exist"assetspecificities").While these statementshelpusunderstandwhen the costsof con-tractingbetween separatelyownedfirmsmaybehigh,theydonotelucidate what the benefits areof"organizingthe transactionwithinthefirm." Inparticular,giventhatit is difficult towriteacompletecontract between abuyerand sellerand this createsroomforoppor-tunisticbehavior,the transactionscost-basedargumentsforintegra-tiondo notexplainhow thescopeforsuchbehaviorchangeswhenoneof the self-interestedownersbecomesanequallyself-interestedemployeeof the otherowner.Furthermore,if verticalintegration

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