Session 10: The boundaries of the firm III: Property Rights

Question 1

Governance structure

Answer 1

Consists of the rules by which an exchange is administered. Aims to compensate for incompleteness of contracts and foster efficient transactions. Exercise of authority, guidance and control.

Question 2

Property rights approach (PRA)

Answer 2

Like transaction costs economic, PRA highlights assets, incomplete contracts. When unforeseen contingencies occur, how are conflicts over the uses of assets resolved?
* Party with the residual rights of control has authority to decide outcome
* Possession of the residual rights of control constitutes “ownership”

Question 3

TCE’s response to market failure

Answer 3

TCE’s respond to market failure: TCE states how the firm should internalize the transaction, when there is a market failure (See lecture 8 example). However, property rights criticize this:
* First critique: Is it consistent, meaningful to assume that people, in an integrated enterprise, do not have opportunistic intentions anymore?

(See picture in notes)

• Second critique: In the above example, who owns who doesn’t matter. But, what if integration affects parties differently? E.g., a party invests more as owner than as employee. Then, the form of integration matters – i.e., the specific pattern of ownership matters.

Question 4

Relevance of governance structures

Answer 4

The reason why we need governance structures is because of incompleteness of contracts creating a difference between ex ante decisions and ex post decisions
(If complete contingent contracts can be designed without costs, then all decision are taken ex ante and the complete quasi surplus is distributed ex ante  No need for governance)

A governance structure adds value for those activities that do not blossom in a market relationship.

Complete contingent contract: no need for governance
Contingent contract: no need for governance
Incomplete contract: need for governance

Purpose: Based on the above, the purpose of governance structures is:
1. To maximize the incentives to generate value-enhancing investments while incentives for developing inefficient influence activities have to be minimized.
2. To minimize risk, and to allocate the residual risk to the least risk-averse party.

Question 5

Ownership and bargaining power

Answer 5

Ownership gives the right to pull the assets out of a relation –> Bargaining power (determines how much value you can appropriate: high bargaining power: High appropriation) –> incentives to invest in a relation ↑ –> Value creation (efficiency)

Question 6

Observable and verifiable actions in contracts

Answer 6

Observable and verifiable actions can be used to conceptualize incompleteness of contracts.

Observable and non-verifiable: Observable by parties involved but cannot be verified by an external party –> Cannot be enforced by a judge, i.e., has no real value.

Observable and verifiable: Can both be observed by the involved parties and verified by an external party. These are meaningful contracts.

Question 7

Contractual rights

Answer 7

Specific rights: Delineates the rights and duties in circumstances that are verifiable –> Specified in contract.

Residual rights: Determines who can decide about the use of the means of production in circumstances not described in the contract –> Not specified.

–> Incompleteness arises from the residual rights, because not everything can be specified ex ante. The residual rights describe ex post allocation of decisions, where the person decides according to his own interest

Question 8

Types of contracts

Answer 8

See picture in notes

Question 9

Standard incomplete contracting model

Answer 9

Consists of three stages:
1. Governance structure stage: Determines the allocation of ownership, i.e., assigns residual decision rights –> Distribution of bargaining power.
2. Investment stage: Considers the choice of investments –> Distribution of bargaining positions.
3. Contract execution stage: Determines whether or not the contract will be honored –> Decision rights allocated for quasi-surplus according to step 1 and 2.

Question 10

Efficient allocation of ownership rights when one party invests

Answer 10

Distribution of quasi-surplus

(See picture in notes)

Equilibrium in different structures:
1. Market (0:0): Sum of producer and consumer surplus is surplus before and surplus after transformation, but distributions are different  This means that the downstream party will always find it attractive to choose hold-up
2. Forward integration (40:0): The inventor has all the bargaining power and appropriates the complete quasi-surplus in the governance structure forward integration <FI>. The downstream party does not need to take a decision about honoring the contract, because there is no bargaining relationship
3. Backward integration (0:0): The downstream party has all the bargaining power in the governance structure backward integration <BI> and appropriates the complete quasi-surplus.</BI></FI>

Effect of different Ks (the non-recoverable cost):
k=0: All three gov structs can realize efficient investment. (”Coase Theorem”)
0<k≤40: Both market and forward integration can realize efficient investment (upstream inventor gets investments covered)
k>40: Only forward integration can realize efficient investment.

Question 11

Efficient allocation of ownership rights when two parties invest

Answer 11

Change of ownership: Transferring ownership of an asset from party 2 to party 1 increases 1’s freedom of action to use the assets as he or she sees fit and therefore increases 1’s share of ex post surplus and ex ante incentive to invest in the relationship, but 2’s share of ex post surplus and incentive to invest falls.

(see picture in notes)

• Vertical integration: An oval.
• Residual rights: An X.

Question 12

Hold up problem

Answer 12

Both parties are supposed to invest in relationship-specific activities, therefore each party are confronted by a hold-up problem. The owner of the project will be mostly incentivized for the success of the investment. Self-interest implies that the parties behave differently depending on whether they are the employer or employee.

Question 13

Complexity

Answer 13

More complexity: Occurs under lower levels of contractual completeness, because it is more expensive and difficult to contract for higher uncertainty –> Entails higher risk that adaptations must be made ex post.
* Negative relationship between complexity and the intensity of incentives faced by the seller.

Question 14

Implications and conclusions of property rights theory

Answer 14

Governance structure: After the investment levels are derived, the efficient governance structure has to be determined.
* Market is best when investments of both parties are equally important, hence, it makes sense that each party receives the same.
* Integration with I as owner is best when the investment of I is more important, hence overinvestment of I weighs up for underinvestment of J.

Implications
- A party that invests in relationship specific assets deteriorates its ex post bargaining position. Giver her sufficient bargaining strength –> confident that the investment will be recouped
- The more specific the investment is (K increase), the more bargaining power a party should get in order to induce her to invest
- You can strengthen the incentives of a party by providing more control over assets - but only at the expense of weakening the incentives of other parties (the costs of ownership)
- Those parties whose investments matter most to value creation should own the assets

Question 15

Coase theorem and Property Rights Theory

Answer 15

Coase: The chapter has shown that desirability of integration depends on circumstances, which is in contrast to the result of the Coase theorem that every assignment of ownership result in the same efficient allocation.

Does the Coase theorem hold? It is assumed that the Coase theorem holds once the contract is concluded. In situations with asymmetric information, the Coase theorem typically does not hold.

Question 16

Hansmann (1988): Focus of the paper

Answer 16

Explore the economic factors responsible for the different patterns of ownership. Both the agency view and the PRT are correct—they are just incomplete. Ownership is the possession of residual decision rights and residual income rights.

Widely shared ownership and costs: Large costs can be caused by conflicting interests when the ownership class is heterogeneous, and that these costs are a primary determinant of the relative efficiency of alternative assignments of ownership

Question 17

Hansmann (1988): Patrons

Answer 17

Ownership falls to a class of patrons (those who transact with the firm: customers, input suppliers, etc.)

Question 18

Hansmann (1988): Which patrons should own the firm?

Answer 18

Ownership falls to a class of patrons, i.e., those who transact with a firm (capital suppliers, customers, input suppliers, workers, etc.)
* Basic TCE idea: Balance the costs of contracting (with non-owning patrons) and the costs of ownership (for owning patrons)
* Lowest total costs: The patron group for which the sum of these two costs is lowest is the efficient owner-group

Question 19

Hansmann (1988): Costs of ownership

Answer 19

Monitoring: Sum of (1) the costs actually incurred by the owners in monitoring management and (2) the costs of managerial opportunism that result from the failure to monitor perfectly.

Collective decision-making: As methods for aggregating the preferences of a group of patrons, such collective choice mechanisms often involve substantial costs in comparison to market contracting

Risk-bearing: Costs are also associated with the second element of ownership: the receipt of compensation in the form of residual earnings. Most conspicuous among these is the cost of bearing the risk of the enterprise and is typically reflected in residual earnings

Question 20

Hansmann (1988): Costs of contracting and costs of ownership

Answer 20

Cost of contracting (with non-owners):
- Monopoly or monopsony
- Contractual lock-in: Relation specific assets (as in TCE/Williamson, session 8)
- Asymmetric Information: One party has specialized knowledge that can be used to exploit the other party (moral hazard, etc.)

Cost of ownership (for owning patrons):
- Monitoring (agency) costs: All else equal, patrons who are least-cost monitors are most efficient owners
- Collective decision-making: How to aggregate the interests of members of a patron class
- Risk bearing: Which patron class is in the best position to bear risk?

Question 21

Hansmann (1988): The public corporation (“A capitalist cooperative”)

Answer 21

A “capitalists cooperative” emerges when:
* Risky, long-term projects: Lenders are particularly likely to have their capital at risk/appropriated because of opportunism/moral hazard from other patrons, particularly when the firm needs to undertake long-term investments, requiring long-term financing
* Risk diversification benefits of investor ownership  They are in a better position to diversify their risk
* Common denominator of profit/max NPV of firm reduces costs of decision-making

Question 22

Hansmann (1988):