4 INTEGRATION
AND ITS
ALTERNATIVES
WHAT DOES IT MEAN TO BE “INTEGRATED?”
I n Chapter 3, we described why firms contract and how contractual incompleteness affects decisions to vertically integrate. Firms rely on contracts to protect themselves from exploitation by their trading partners. Complete contracts spell out exactly what actions should be taken by which firms; if contracts were complete, integration would be unnecessary. But contracts are invariably incomplete, so that self-interested firms have leeway to take steps to boost their own profits at the expense of other firms in the vertical chain. The resulting coordination, information leakage, and holdup problems may lead to inefficient production. Integration may be necessary to ensure efficient production and successful competition in the finished goods market.
The Property Rights Theory of the Firm
Performance issues associated with coordination, information, and holdup are not just theoretical constructs. They result when people make inefficient decisions about how to use available resources. Technically speaking, integration is merely the transfer of ownership of assets from one group of individuals to another. Vertical integration does not eliminate the people or the resources involved in production (although the new owner could choose to fire or replace workers and sell or replace physical assets). Nor does vertical integration typically change the steps in the production process. How, then, does integration lead to improved performance?
The Property Rights Theory (PRT) of the firm, developed by Sanford Grossman, Oliver Hart, and John Moore, explains how integration affects performance in the vertical chain.1 The main proposition of PRT is as follows:
Integration determines the ownership and control of assets, and it is through ownership and control that firms are able to exploit contractual incompleteness.
In other words, integration matters because it determines who gets to control resources, make decisions, and allocate profits when contracts are incomplete and trading partners disagree. When the wrong firm has ownership rights, efficiency suffers.
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The PRT begins with a simple but important observation: the resolution of the make-or-buy decision determines the legal right to control assets and disburse revenues obtained from use of the assets. The owner of an asset may grant another party the right to use it or receive revenues from it, but the owner retains all rights of control that are not explicitly stipulated in the contract. These are known as residual rights of control. When ownership is transferred, the residual rights of control are transferred as well.
To clarify the concept of residual rights of control, consider the relationship between PepsiCo and its bottlers. PepsiCo has two types of bottlers: independent and company owned. An independent bottler owns the physical assets of the bottling operation and the exclusive rights to the franchise territory. PepsiCo has no direct authority over how the independent bottler manages its operations. If a bottler refuses to stock particular stores or participate in a national campaign like the famous Pepsi Challenge (launched in 1975), PepsiCo can only try to persuade the bottler to cooperate. Suppose, however, that PepsiCo acquires one of its independent bottlers. Unless stated otherwise in a contract, PepsiCo would have the ultimate authority over how the bottling assets are deployed and how the bottler’s territory is managed. If the management of the bottling subsidiary refused to participate in the Pepsi Challenge, PepsiCo could replace them with a more cooperative team.
If contracts were complete, it would not matter who owned the assets. Guided by a complete contract, PepsiCo and its bottlers would always know how to resolve disagreements about marketing campaigns, regardless of who owned whom. Taking incomplete contracting as a starting point, the PRT analyzes how ownership affects the willingness of parties to invest in relationship-specific assets. The theory considers a situation in which two firms (or individuals) enter a transaction with each other. To carry out the transaction, the firms must jointly make an array of operating decisions. The theory assumes that they cannot write a contract that specifies these operating decisions in advance. Instead, they must bargain over them once the transaction is underway. Ownership affects the outcome of this bargain, and therefore ownership affects productive efficiency.
Alternative Forms of Organizing Transactions
To better understand PRT, think of two firms, each of which has its own set of managers. For convenience, we will suppose that firm 1 is upstream from firm 2 in the vertical chain. Decisions made by both sets of managers are important to the efficiency of the vertical chain. Moreover, conditions of supply and demand are such that there is no simple contract that would dictate how each set of managers should act. For example, the market environment might be constantly changing, so that a contract one year ago may not give adequate direction to these managers today.
We can imagine three alternative ways to organize the transaction:
1.Nonintegration: The two firms are independent; each set of managers has control over its own assets.
2.Forward Integration: Firm 1 owns the assets of firm 2 (i.e., firm 1 forward integrates into the function performed by firm 2 by purchasing control over firm 2’s assets).
3.Backward Integration: Firm 2 owns the assets of firm 1 (i.e., firm 2 backward integrates into the function performed by firm 1 by purchasing control over firm 1’s assets).
134 • Chapter 4 • Integration and Its Alternatives
PRT establishes that the form of integration affects the incentives of both sets of managers to invest in relationship-specific assets. This includes both ex ante investments and ongoing investments and other operating decisions that emerge as the relationship evolves. (Chapter 3 describes these investments and operating decisions.) Because these investments and operating decisions may cost one firm more than another, each set of managers may haggle over responsibilities with the result that there is inefficient adaptation to the changing market environment.
PRT suggests that the form of integration can affect the degree of haggling and maladaptation. Suppose, for example, that firm 1 forward integrates and acquires firm 2. By owning firm 2’s assets, the managers of firm 1 have a better bargaining position when they negotiate over the operating decisions that could not be contracted. With a better bargaining position, the managers can capture more of the economic value created by the transaction, thus boosting their willingness to make relationship-specific investments. Both sets of managers would welcome this if the investments were valuable to the relationship because these investments would make the vertical chain more efficient. The theory implies that vertical integration is desirable when one firm’s investment in relationship-specific assets has a significantly greater impact on the value created in the vertical chain than does the other firm’s investment. When the investments of both firms are of comparable importance, nonintegration is the best arrangement, as both firms’ managers will have sufficient incentives to invest while remaining independent.
This suggests that there are trade-offs in alternative ownership structures. For example, consider the decision of an insurance company to forward integrate into sales—that is, whether the company should use an in-house sales force or sell through independent agents. A key investment involves the time required to develop “client lists”—lists of actual and potential insurance purchasers. According to PRT, the integration decision should turn on the relative importance of investments in developing persistent clients by the agent versus list-building activities by the insurance firm. If customers are loyal to agents, then investments by agents matter. If customers are loyal to the insurance company, then investments by the company matter. It turns out that a purchaser of whole life insurance tends to remain loyal to the company, while a purchaser of term life insurance tends to be loyal to the agent. PRT implies that whole life insurance would typically be sold through an insurance company’s in-house sales force. This is consistent with industry practice: most companies that offer whole life insurance have their own sales forces. By contrast, many insurance companies rely on independent agents who own the client list to sell term life coverage.
By emphasizing the importance of asset ownership, PRT helps us understand certain real-world arrangements that fall between vertical integration and arm’s- length market contracting. For example, General Motors and Ford often own their own specialized tooling and dies, even though an independent firm produces body parts and components. This is especially likely for components, such as radiators and starters, that require specialized physical assets but do not require much specialized engineering or operational know-how.2 Similarly, in the glass bottle industry, large buyers will often retain ownership of specialized molds, even though an independent manufacturer produces the jars and bottles. PRT implies that this is a form of vertical integration and is distinct from the situation in which the independent supplier carries out production and owns the physical asset.
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EXAMPLE 4.1 VERTICAL INTEGRATION IN A MOUNTAIN PARADISE
Strategy gurus often say that firms should “stick to their knitting,” taking on only those activities they know best. But asset specificity often requires firms to perform activities that are far removed from their core competencies. One happy example took place a century ago in isolated, cold, rugged, and beautiful terrain.
The Banff/Lake Louise region of the Canadian Rockies is truly among the natural wonders of the world. The combination of snow-capped peaks, floral-laden mountain valleys, ice fields, and glacier-fed clear blue lakes is breathtaking. Many travelers believe that Lake Louise is the most picturesque spot on earth, and the mountains near Banff have some of the world’s best skiing.
Every year, tens of thousands of tourists visit the region from all over the world. Many are fortunate to stay at the Chateau Lake Louise and the Banff Springs Hotel. The two resorts are situated less than an hour apart and have a combined 1,270 beds. They are frequently listed among the finest resorts in the world and for good reason. Not only do they offer spectacular natural scenery, but both resorts have several fine restaurants, spa facilities, horseback riding, hiking trails, and everything else required for a complete vacation. A popular vacation package includes a three-night stay at each resort. Golfers are especially attracted by the prospect of launching 3001 yard drives from the mile-high tees in Banff.
Until the late nineteenth century, the region around Banff/Lake Louise was known only to a few intrepid explorers and naturalists. The area is accessible by the Bow River, which is fed by Lake Louise glacial waters and flows 400 miles past Calgary before feeding the Saskatchewan River (and eventually Hudson Bay). During the 1880s, the Bow River valley proved to be a perfect location for the Canadian Pacific (CP) Railroad as it laid a section of the transcontinental railroad between Calgary (just east of the Canadian Rockies) and Vancouver. In 1883, CP railway workers discovered natural hot springs at the base of Sulphur Mountain, near the
conjunction of the Bow and Spray rivers. Shortly thereafter, Canada established Banff National Park—the nation’s first—including the hot springs and the surrounding region. Today, Banff National Park stretches for 2,564 square miles and includes all of Banff and Lake Louise.
Despite the new rail line and national park, few tourists came, mainly because there was no place for them to stay. William Van Horne, the general manager of the Canadian Pacific, struck on a novel idea. Fueled by the philosophy, “If we can’t export the scenery, we will import the tourists,” he ordered the construction of the Banff Springs Hotel at the base of Sulphur Mountain, as well as a series of other resorts on or near the rail line, to include the Chateau Lake Louise. With CP controlling access to the region, it had no choice but to build these hotels itself. No one else would risk such massive investments when the rail line owned the only means of access.
Once Van Horne’s vision was realized, the trains and the resorts filled up. Through the mid-twentieth century, CP continued to build new resorts in the Rockies, as well as expand its flagship resorts in Banff and Lake Louise. The Trans-Canada Highway opened in 1962, creating new opportunities for tourists to access the Canadian Rockies. New motels and hotels sprung up in Banff. (The area around Lake Louise is not large enough to support additional development.) As Calgary boomed following the 1988 Olympics (and its airport began handling more flights), tourism to the region skyrocketed. Today, the town of Banff has 7,500 year-round residents and dozens of motels, hotels, and resorts.
Forced to develop its own expertise in operating luxury hotels, Canadian Pacific has become a leading hotelier worldwide. Now a freestanding subsidiary (in accordance with the advice of the gurus!), Canadian Pacific Hotels acquired the CN hotel chain in 1988 and the world-famous Fairmont chain in 1999. Today, the Banff Springs Hotel and the Chateau Lake Louise operate under the Fairmont name.