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EXAMPLE 4.2 GONE IN A HEARTBEAT: THE ALLEGHENY HEALTH EDUCATION AND RESEARCH FOUNDATION BANKRUPTCY
The 1990s were years of substantial vertical integration in health care. Integrated health care systems such as the Henry Ford Clinic in Michigan and the Sutter system in California consolidated the vertical chain, placing hospitals, physician offices, home health care, pharmacies, health insurance, and diagnostic imaging facilities in a single corporate entity. By the end of the decade, many systems were foundering, having gone the route of vertical integration regardless of the economic fundamentals.
For a short time, the Allegheny Health Education and Research Foundation (AHERF) was at the forefront of the integration movement. Beginning in the early 1990s, AHERF started gobbling up hospitals and physician practices throughout the Philadephia market. AHERF’s strategy was unexceptional in most ways—hospitals across the United States were creating similar systems—except AHERF moved faster than most and piled on loads of debt in the process. The economic motivation was “bigger is better,” and few in the industry (except for a few skeptical economists) were arguing otherwise. AHERF even partially integrated into health insurance, following yet another trend that would prove disastrous. AHERF’s CEO Sherif Abdelhak was widely admired for riding the integration wave harder and, it seemed, more successfully than anyone else.
But bigger did not prove to be better. AHERF could not achieve economies of scale because it was unable to integrate clinical services across hospitals. The reason should have been anticipated but was not: it was difficult, if not impossible, to convince physicians to move
their practices from one hospital to another. (The same problem plagued horizontal integration efforts throughout the nation.) AHERF suffered even more from its vertical strategies. AHERF competed with other hospital systems to acquire physician practices, often paying substantial premiums above the practice earnings. Once they became employees, the acquired physicians slacked off, working shorter hours and not even trying to increase referrals to AHERF hospitals. (Some studies suggest that physician effort declined by as much as 10 percent after acquisition.) And AHERF proved to be a naïve player in the health insurance business. AHERF allowed private insurers to sign up policy holders, but AHERF remained responsible for all the medical costs. As a result, insurers grew lax in medical underwriting (the practice of predicting the medical needs of enrollees), leaving AHERF exposed to an undesirable, unattractive risk pool. Systems like AHERF had margins of 210 percent or worse on their insurance business.
In 1997, AHERF was bankrupt. In a heartbeat, AHERF went from the industry darling to owing creditors $1.5 billion, making this the largest nonprofit bankruptcy in U.S. history. By 2000, the vertical integration wave in health care was over. Hospitals were spinning off their physician practices and getting out of the insurance business. Health care systems are again on the rise, but this time they are built around integration of clinical information technology and disease management systems, both of which require considerable asset specificity and coordination.
REAL-WORLD EVIDENCE
Evidence suggests that many real-world firms behave in accordance with these principles. The evolution of the modern hierarchical firm discussed in Chapter 1 is consistent with the product market scale and the asset-specificity rationales for integration. A key step in the growth of the modern firm was forward integration by
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manufacturers into marketing and distribution. Between 1875 and 1900, technological breakthroughs allowed for unprecedented economies of scale in manufacturing industries. This, coupled with improvements in transportation and communication that expanded the scope of markets, led to vast increases in the size of firms in capital-intensive industries, such as steel, chemicals, food processing, and light machinery.
As these firms grew, independent wholesaling and marketing agents lost much of their scaleand scope-based cost advantages. As this happened, manufacturers forward integrated into marketing and distribution, a result consistent with the firm-size hypothesis. As predicted by the asset-specificity hypothesis, forward integration was most likely to occur for products that required specialized investments in human capital (e.g., George Eastman’s marketing of cameras and film) or in equipment and facilities (e.g., Gustavus Swift’s refrigerated warehouses and boxcars). For those industries in which manufacturers remained small (e.g., furniture or textiles) and/or marketing and distribution did not rely on specialized assets (e.g., candy), manufacturers continued to rely on independent commercial intermediaries to distribute and sell their products.
Around the time of the publication of Williamson’s The Economic Institutions of Capitalism, (which we discussed in Chapter 3), strategy researchers looked for realworld validation of transactions cost theory. Consider these examples:
Automobiles In a classic and oft-cited study, Kirk Monteverde and David Teece examined the choice between vertical integration and market procurement of components by General Motors and Ford.5 Monteverde and Teece surveyed design engineers to determine the importance of applications engineering effort in the design of 133 different components. Greater applications engineering effort is likely to involve greater human asset specificity, so Monteverde and Teece hypothesized that car makers would be more likely to produce components that required significant amounts of applications engineering effort and more likely to buy components that required small amounts of applications engineering effort. Their analysis of the data confirmed this hypothesis. They also found that GM was more vertically integrated than Ford on components with the same asset specificity. This is consistent with the firm-size hypothesis.
Aerospace Industry Scott Masten studied the make-or-buy decision for nearly 2,000 components in a large aerospace system.6 He asked procurement managers to rate the design specificity of the components—that is, the extent to which the component was used exclusively by the company or could be easily adapted for use by other aerospace firms or firms in other industries. Consistent with the asset-specificity hypothesis, Masten found that greater design specificity increased the likelihood that production of the component was vertically integrated. He also studied the effect of the complexity of the component, that is, the number of relevant performance dimensions and the difficulty in assessing satisfactory performance. When the item being purchased is complex, parties in an arm’s-length market transaction find it hard to protect themselves with contracts. As theory predicts, Masten found that more complex components were more likely to be manufactured internally.
Electric Utility Industry Paul Joskow studied the extent of backward integration by electric utilities into coal mining.7 Coal-burning electricity-generating plants are sometimes located next to coal mines. Co-location reduces the costs of shipping coal and encourages investments that maximize operating efficiency. The utility in a
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“mine-mouth” operation will typically design its boilers with tight tolerances to accommodate the quality of coal from that particular mine. The utility may also make large investments in rail lines and transmission capacity, and the mine will often expand its capacity to supply the on-site utilities. The relationship between the utility and the mine thus involves both site and physical-asset specificity. Joskow found that mine-mouth plants are much more likely to be vertically integrated than other plants. Where mine-mouth plants were not vertically integrated, Joskow found that coal suppliers relied on long-term supply contracts containing numerous safeguards to prevent holdup.
Electronic Components Erin Anderson and David Schmittlein studied vertical integration between electronics manufacturers and sales representatives.8 Manufacturers’ reps operate like the sales department of a firm except that they usually represent more than one manufacturer and work on a commission. Anderson and Schmittlein surveyed territory sales managers in 16 major electronics component manufacturers to determine the extent to which they relied on independent reps or on their own sales forces in a given sales territory for a given product. The survey measured the amount of asset specificity in the selling function and the degree of difficulty in evaluating a salesperson’s performance. The measure of asset specificity embraced such factors as the amount of time a salesperson would have to spend learning about the company’s product, the extent to which selling the product would necessitate extra training, and the importance of the personal relationship between the salesperson and the customer. Anderson and Schmittlein found that greater asset specificity in the selling function was associated with a greater likelihood that firms rely on their own sales forces rather than manufacturers’ reps. They also found that holding asset specificity constant, larger manufacturers were more likely to use a direct sales force than smaller firms. Finally, they found that the more difficult it was to measure performance, the more likely manufacturers were to rely on direct sales forces. All of these findings are consistent with theories of vertical integration.
Automobiles Redux Although the concepts are so well established that it has become less fashionable to publish research on transactions costs, a recent study by Sharon Novak and Scott Stern explores some of the nuances of the theory.9 They observe that outsourcing “facilitates access to cutting-edge technology and the use of high-powered performance contracts,” while vertical integration allows firms to adapt to unforeseen circumstances and develop firm-specific capabilities over time. Taken together, these factors suggest that firms may achieve higher initial performance by outsourcing but may have greater ability to improve performance by moving production in-house. Evidence from the luxury automobile segment confirms these ideas. More highly integrated manufacturers have poorer initial quality but also enjoy significantly faster quality improvements. The benefits of integration are higher when firms have greater preexisting capabilities and fewer opportunities to access external technology leaders.
Double Marginalization: A Final Integration Consideration
When a firm with market power (e.g., an input supplier) contemplates vertical integration with another firm with market power (e.g., a manufacturer), it needs to consider one additional factor known as double marginalization. Recall from the Economics
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EXAMPLE 4.3 VERTICAL INTEGRATION OF THE SALES FORCE IN
THE INSURANCE INDUSTRY
In the insurance industry, some products (e.g., whole life insurance) are usually sold through in-house sales forces, while other products (e.g., fire and casualty insurance) are mainly sold through independent brokers. The Grossman/ Hart/Moore (GHM) theory helps us understand this pattern. Relying on independent agents versus in-house sales employees is essentially a choice by the insurance firm for nonintegration versus forward integration into the selling function. This choice determines the ownership of an extremely important asset in the process of selling insurance: the list of clients. Under nonintegration, the agent controls this key asset; under forward integration, the insurance firm controls it.
If the agent owns the client list, the agent controls access to its clients; clients cannot be solicited without the agent’s permission. A key role of an insurance agent is to search out and deliver dependable clients to the insurance company, clients who are likely to renew their insurance policies in the future. To induce an agent to do this, the commission structure must be “backloaded,” for example, through a renewal commission that exceeds the costs of servicing and re-signing the client. When the insurance company owns the client list, however, this commission structure creates incentives for the company to hold up the agent. It could threaten to reduce the likelihood of renewal (e.g., by raising premiums or restricting coverage) unless the agent accepts a reduced renewal commission. Faced with the possibility of this holdup problem, the agent would presumably underinvest in searching out and selling insurance to repeat clients. By contrast, if the agent owned the client list, the potential for holdup by the insurance company would be much weaker. If the company did raise premiums or restrict coverage, the agent could invite its client to switch companies. Threats by the company to jeopardize the agent’s renewal premium would thus have considerably less force, and underinvestment in the search for persistent clients
would not be a problem. In some circumstances, the holdup problem could work the other way. Suppose the insurance company can engage in list-building activities such as new product development. The agent could threaten not to offer the new product to the customer unless the insurance company paid the agent a higher commission. Faced with the prospect of this holdup, the company is likely to underinvest in developing new products. By contrast, if the insurance company owned the list, this type of holdup could not occur, and the insurance company’s incentive to invest in new product development would be much stronger.
This suggests that there are trade-offs in alternative ownership structures that are similar to those discussed above. According to the GHM theory, the choice between an in-house sales force versus independent agents should turn on the relative importance of investments in developing persistent clients by the agent versus list-building activities by the insurance firm. Given the nature of the product, a purchaser of whole life insurance is much less likely to switch insurance companies than, say, a customer of fire and casualty insurance. Thus, the insurance agent’s effort in searching out persistent clients is less important for whole life insurance than it is for fire and casualty insurance. For whole life insurance, then, backloading the commission structure is not critical, which diminishes the possibility of contractual holdup when the insurance company owns the client list.
The GHM theory prediction that whole life insurance would typically be sold through an insurance company’s in-house sales force is consistent with industry practice: most companies that offer whole life insurance have their own sales forces. By contrast, for term life or substandard insurance, the agent’s selling and renewalgeneration efforts are relatively more important. Consistent with the GHM theory, many insurance companies rely on independent agents who own the client list to sell these products.