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Friends Do Matter (1998)

Friends Do Matter (1998)

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Published by Alberto Cottica
In the literature on vertical integration little attention has been paid to the role of strategic uncertainty, that is, the presence of multiple selfenforcing outcomes which might lead to coordination failure. However, the natural solution to this problem, which is vertical integration, is not the only way out if the agents have some degree of freedom in designing the industrial relations they engage. A game-theoretic model is provided to show how some of the most popular forms of vertical contractual relations can be derived as equilibria of a multi-stage game in which firms bargain over their reciprocal vertical control, in order to minimize the inefficiency created by strategic uncertainty.

(with Lisa De Propriis and Giovanni Ponti)
In the literature on vertical integration little attention has been paid to the role of strategic uncertainty, that is, the presence of multiple selfenforcing outcomes which might lead to coordination failure. However, the natural solution to this problem, which is vertical integration, is not the only way out if the agents have some degree of freedom in designing the industrial relations they engage. A game-theoretic model is provided to show how some of the most popular forms of vertical contractual relations can be derived as equilibria of a multi-stage game in which firms bargain over their reciprocal vertical control, in order to minimize the inefficiency created by strategic uncertainty.

(with Lisa De Propriis and Giovanni Ponti)

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Published by: Alberto Cottica on Mar 16, 2007
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01/01/2013

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F
RIENDS
D
O
M
ATTER
:S
TRATEGIC
U
NCERTAINTY AND
V
ERTICAL
C
ONTRACTUAL
R
ELATIONS
*
A
LBERTO
C
OTTICA
L
ISA
D
E
P
ROPRIS
G
IOVANNI
P
ONTIUCLU
NIVERSITY OF
B
IRMINGHAM
UCL and ELSE
A
BSTRACTIn the literature on vertical integration little attention has been paid tothe role of
strategic uncertainty,
that is, the presence of multiple self-enforcing outcomes which might lead to coordination failure. However,the natural solution to this problem, which is vertical integration, is notthe only way out if the agents have some degree of freedom indesigning the industrial relations they engage. A game-theoretic modelis provided to show how some of the most popular forms of
vertical contractual relations 
can be derived as equilibria of a multi-stagegame in which firms bargain over their reciprocal vertical control, inorder to minimize the inefficiency created by strategic uncertainty.J
EL
C
LASSIFICATION
N
UMBER
: D23, D21K
EYWORDS
: Industrial Organization, Vertical Integration, Game TheoryC
ORRESPONDING
A
UTHOR
: Giovanni Ponti - Department of Economics - University of CaliforniaSanta Barbara, CA 93106-9210.E-M
AIL
: g.ponti@ucl.ac.uk
*
The authors are grateful to Titti Battagion, Patrizio Bianchi, Sebastiano Brusco, Vincenzo De NIcolò, Peter Sinclair and DavidUlph for suggestions and comments. Usual disclaimers apply.
1
 
1. I
NTRODUCTIONWhy cannot a collection of small firms do what a large firm does?Paraphrasing Williamson[1985], who originally posed the question the other way round, we claim that
vertical control 
can be in many circumstances a suitable alternative to
vertical integration.
Market can work aswell as hierarchy, whenever the agents have some degree of freedom in designing thecontractual arrangements they engage.According to Coase [1937], if transactions were costless, then the organisation of economicactivities would be indifferent between taking place either on the market or within the firm. .The dichotomy between
market 
and
hierarchy 
as institutional arrangements, has been alsoanalyzed by Williamson [1975, 1985] by arguing that the internalisation of transactions withinthe firm, as an institution embodying some authority, allows transaction costs to be greatlyreduced. The existence of firms as a vertically integrated institutions, where contracts areinternalised, is there explained in terms of transaction costs reduction compared with the casewhere the same transaction was carried out in a purely decentralized setting. An additionalargument to endorse the thesis in favour of vertical integration comes from the theory ofproperty rights1, according to which ownership, and therefore vertical integration, matterswhen contracts are incomplete, and it is therefore impossible for parties to specify all thepossible contingencies in the contractual agreement.A good example of the methodology pursued by this line of research comes from Grossmanand Hart [1986]. In their model, ownership is defined by means of the control over the residualproperty rights left unspecified by the (incomplete) contractual agreement. The “efficiency” ofthe vertical relation is derived from the comparison between ex-post profits and ex-antedecisions: integration is optimal when one firm’s strategic choice is particularly importantrelative to the other firm’s (in terms of cumulative ex-post payoff) whereas non integration isdesirable when both choices are “...
somewhat important.
..”.
2
As in Williamson, in Grossman and Hart’s model firms face a dichotomic choice: they have todecide whether to merge or not. However, the nature of economic transactions and the relativeresponse to the cost reduction issue has seemed to produce a wide range of institutionalarrangements in between market and hierarchy, which have mostly been neglected by the mainliterature. Rather than exploring the spectrum of these intermediate solutions, the attention hasbeen focused on the dichotomy between these two extremes.However, control can differ from ownership. The study of
vertical contractual relations 
3
 
isgaining reputation in the field by focusing on the alternative means by which independent firmsoperating at successive stages along the production chain may decide to coordinate, up to acertain extent, their actions
as i
they were parts of a unified structure. In those circumstances,where integration is not the optimal option4, when properly characterised, vertical contractual
1See Hart [1995] for a survey on this line of research.2
See Grossman and Hart [1986], p. 717.3See, for example, Katz [1989] and Klein
et al 
[1978].
4
But once it becomes economical to have market transaction, it also pays to divide production in such a way that cost of organising an extra transaction in each firm is the same 
.” (Coase [1937], p. 95) Also, “
Integration holds no advantage over once-for- all contracts in a perfectly static environment 
.” (Williamson [1985], p. 89)
2
 
agreements are capable of achieving results not at all worse than those achieved by one singlelarge vertically integrated firm, still maintaining intact the benefits, by means of an efficientincentive structure, which are naturally embodied in market transactions.
Quantity-dependent pricing 
,
ties,
 
requirement contracts 
and
exclusive dealings,
to make some examples, are oftenquoted as cases of these vertical contractual relations. Some of these practices involve initiativeand autonomy all along the vertical chain
,
posing problems which range from verticalnegotiation, to vertical strategic interaction and to vertical control.The broad label of “vertical contractual relation” embraces industrial districts, clusters ofsmall- and medium-sized firms, exclusive networks and all those productive structures whichinvolve vertical disintegration of activities. Nonetheless, these inter-firm contractual solutionsare deeply different in many respects: the relative role and weight of single firms, the nature offirms’ cooperation and, above all these, the degree of hierarchy in firms’ vertical agreements.
5
In this paper, we compare three vertical integration patterns:market transactions,vertical integration andvertical contractual relationswhen the vertical relationship involves innovation. Innovation differs from other intermediarygoods exchanged in vertical relationships because of the key role played by uncertainty.Regardless the amount of resources invested in R&D activity, the effort and the time devoted toit, the outcome of any innovative activity is uncertain. Moreover, innovation can be exchangedonly through a fixed pricing mechanism, given the non-separability of the innovative outcome. Inother words, once the innovation has occurred, the innovator and the adopter have to agree onthe price at which the whole innovation is transferred.The aim of the paper is to investigate firms’ strategic decisions on vertical control in thespecial case where vertical contracts regard innovation. According to the structure of the finalmarket given by the distribution of profits, firms may decide strategically on the degree ofvertical control over the innovation process. We argue that the vertical integration of innovativeand productive activities in one single firm does not necessary brings about an efficient outcome.Rather, the specialisation of two firms, for instance, in each of the two activities and theexchange of innovation for a transfer fee through vertical contractual relations can generate noworse results.To tackle the problem of vertical control, we model explicitly a multi-stage market gamebetween two upstream and downstream firms. Payoffs are function of the competitive features ofthe downstream market. One payoff parametrization replicates (in our view) Grossman and Hartframework: market does not allocate “efficiently” property rights, since it does provide “toomany” incentives to the upstream firms to diffuse the innovation as it would not happen in thepresence of vertical integration. However, our analysis discloses other possible worlds, wherethe inefficiency is due instead to the presence of
strategic uncertainty,
as the strategic
5
For a taxonomy, see Becker and Peters [1995].
3

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