Week 3 - Vertical Boundaries of the Firm and Incomplete Contracts Flashcards
Case Study: Australia’s chicken meat industry
- The chicken meat industry is predominantly vertically integrated.
- This means that generally, individual companies own almost all aspects of production:
o Breeding farms
o Multiplication farms
o Hatcheries
o Feed mills
o Some broiler farms and
o Processing plants. - Two large integrated national companies supply more than 70% of Australia’s broiler chickens.
- Infrastructure costs are high.
- Feed costs make up about 70% of the cost of producing a live chicken.
o Therefore an increases in feed grain prices is detrimental. - Chicken popularity has grown over the years.
o It used to be a rare meal, now the Australian chicken industry produces around 600 million chickens a year.
Why do firms primarily use the market?
Because market firms are often more efficient.
- However, sometimes it makes sense for firms to make rather than buy.
Why does it sometimes make sense for firms to make rather than buy?
Transactions among market firms can create serious problems for the profitability of all firms in the vertical chian.
- This is because owners of market firms have hard-edged incentives to maximise their own profits, without regard to the profits of their trading partners.
- Firms could write contracts to blunt these incentives, by penalising market firms that look after their own interests and rewarding those market firms that help their trading partners become more profitable.
What are the costs of contracts?
They are costly to write and enforce.
- Vertical integration is inevitable when there are severe contracting issues.
What do contracts define?
The condition of exchange.
- They may take standardized forms, such as “conditions of contract” on the back of an airline ticket or the terms and conditions of purchases printed on the back of a company’s purchase order.
- Or they may be lengthy and complicated because they are carefully tailored to a specific transaction.
o E.g. contract for the sale of the Empire State Building in he 1960s involved more than 100 attorneys and was over 400 pages long
What are the types of contracts?
Contracts can be categorised into two types:
- Complete contracts
o This stipulates each party’s responsibilities and rights for each and every contingency that could conceivably arise during the transaction.
o The requirements for complete contracts are severe.
o Parties to the contract must be able to contemplate all relevant contingencies and agree on a set if actions for every contingency.
o The parties must also be able to stipulate what constitutes satisfactory performance and must be able to measure performance.
o Finally, the contract must be enforceable.
- Incomplete contracts
o Not all possible contingencies are considered.
o Virtually all real-world contracts are incomplete.
What are some factors that prevent complete contracting?
- Bounded rationality:
o Limits on the capacity of individuals to process information, deal with complexity and pursue rational aims. - Difficulties specifying or measuring performance:
o When performance under a contract is complex, no even the most accomplished wordsmiths may be able to spell out each party’s rights and responsibilities. - Asymmetric information
o One party knows some relevant information, but the other party does not. The knowledgeable party may distort or misrepresent that information.
What happens when there isn’t good coordination in the vertical chain?
Without good coordination, bottlenecks may arise.
- The failure of one supplier to deliver parts on schedule can shut down a factory.
- Firms rely on contracts to ensure coordination (as these may specific delivery dates, design tolerances and performance targets).
Why may it be hard to recover full economic damages when poor coordination results in substantial costs?
In some circumstances the protections afforded by contracts may be inadequate.
- Whether by accident or design, an upstream supplier may fail to take the steps necessary to ensure a proper fit.
- If the resulting cost is substantial, then even if the downstream firm seeks compensation in court, it may be unable to recover full economic damages.
- Confronting such a possibility, the downstream firm may wish to integrate all critical activities and rely on administrative control to achieve the appropriate coordination.
What are the costs of using the market referred to?
Transaction costs, which include the time and expense of negotiating, writing and enforcing contracts as well as potentially far greater costs that arise when firms exploit incomplete contracts to act opportunistically.
What are the 3 theoretical concepts on transaction costs?
- Relationship-specific assets
- Quasi-rents (extra profit you get if the del goes ahead as planned, versus the profit you would get if you had to turn to your next-best alternative)
- The holdup problem
What is a relationship-specific asset?
This is an investment made to support a given transaction.
- It cannot be redeployed to another transaction without some sacrifice in the productivity.
- Firms that have invested in relationship-specific assets cannot switch trading partners without seeing a decline in the value of these assets.
What are the 4 forms of asset specificity?
- Site specificity
o Assets are located side-by-side to economise on transportation or inventory costs or to take advantage of processing efficiencies. - Physical asset specificity
o Assets whose physical or engineering properties are specifically tailored to a particular transaction. - Dedicated assets
o An investment in plant and equipment made to satisfy a particular buyer. - Human asset specificity.
o Workers acquire skills, know-how, and information that are more valuable inside a particular relationship than outside.
What is the hold-up problem?
- When a firm invests in a relationship-specific asset, a holdup problem could arise when the contract is incomplete.
- A firm holds up its trading partner by attempting to renegotiate the terms of a deal.
- A firm can profit by holding up its trading partner when contracts are incomplete (thereby permitting breach) and when the deal generates quasi-rents for its trading partner.
- The holdup problem makes contract negotiations more difficult.
- The holdup problem causes insufficient relationship-specific investments.
What is an example of the hold-up problem?
Power barges in developing countries:
- Developing countries have difficulties to convince foreign corporations to construct power plants.
- Power plants are highly specialised and relationship-specific (site-specific).
- If the purchasing government defaults, the manufacturers make losses.
- To eliminate the geographic asset specificity, manufacturers build power plants on floating barges.
- Innovations allowed power barges to house large-capacity generators.
- If the government defaults, the barges can be towed away and sell to other countries.
