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Conflicts in integration theory

A BSTRACT

3. THEORETICAL DILEMMAS AND EMPIRICS

3.0 Conflicts in integration theory

When trade and interaction no longer represent simple spot markets, the competition and conflict between different theoretical rationales and perspectives become visible in the distinction between first, second, and third-order economizing (Williamson, 1998). 1st order economizing focuses on the institutional environment of government policies, laws, administrative structures, the efficiency of the legal system, and property rights that dictate the rules of the game when organizing for economic productivity. 2nd order economizing deals with inter-firm governance approaches and how to operate under prevailing market structures and trading relations. The governance approach and its contractual set-up are important to minimize transaction costs and through this, optimize production efficiencies. 3rd order economizing is focused on management concerns where important managerial decisions consider analyses of marginal performance effects and internal efficiencies. Usually 1st order economizing is considered as being outside the direct influence of firms. The reason being that this level has been shaped through long-term non deliberate actions like informal traditions, norms, religion, institutions, and even revolutions that have influenced regional and national legislation, legal systems and political governance approaches. In contrast, 2nd and 3rd order economizing are left

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to independent actors, like firms, to decide on. This means that firm owners must decide on issues like the efficiency of the legal system for solving disputes, but also on what ownership structure provides the most efficient coordination and incentives.

As the discussion of vertical boundaries illustrates, different theories cater to solve different economic challenges of operating either within 2nd order economizing, that is market trade or integration, or 3rd order economizing, that is, creating the optimal conditions for marginal performance and internal efficiencies. While integration in some instances can solve costs related to transactions across markets, we cannot assume that new costs do not remain “if the factors which makes haggling very inefficient under non-integration are correlated with those that make abuse of fiat very inefficient under integration” (Gibbons, 2010: p. 277). In other words, the decision to integrate cannot assume that possibilities for internal opportunism will disappear. Therefore, the ex post integrated firm is not just a ‘black box’ where internal opportunism can conveniently be assumed away. When firms expand and integrate they create (different) internal structures to make efficient use of resources and competences (Jensen and Meckling, 1990). They can also create incentives to allocate resources effectively (Brickley et al., 2015). This opens for a potential dilemma as integration may distort the incentives provided by segregated asset ownership, where owners were residual claimants to their own non-contractible efforts (Grossman and Hart, 1986; Tirole and Holmström, 1991).

If a firm makes an integration decision based on transaction cost economics, the primary concern is on 2nd order economizing, e.g., trying to minimize the costs of transacting across markets. However, after integration management must deal with 3rd order economizing issues of opportunism and moral hazard by establishing contractual arrangements, monitoring systems, and aligned incentives to exploit the economic opportunities offered by the integration.

Adopting one particular theoretical rationale to support these diverse decisions can possibly lead to contravening effects that dilute the economic advantages of integration. If a manufacturer has asset specific investments, they are subject to opportunistic appropriation of quasi rents by distribution based on transaction cost economic rationales. At the same time we find situations where distribution has important investment incentives that are non-contractible with manufacturing argued from a property rights perspective (Grossman and Hart, 1986; Whinston, 2003; Woodruff, 2002). This can be resolved by segregating the ownership of assets. The segregation of ownership is recommended because the non-contractible investments will be

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executed by the residual claimants to the generated quasi rents. This sets the course for potential conflicts between transaction cost and property rights theory. The reason for this is that transaction cost economics perceive contractible asset specific investments as vulnerable to opportunistic hold-ups arguing in favor of forward integration. Property rights theory on the other hand addresses the importance of non-contractible investments arguing in favor of segregated ownership. That is, adopting different economic rationales lead to contradictory and directly opposing recommendations. Hence, we often see firms with multiple divisions where the integration decision is unable to distinguish between the conflicts arising from contractible and non-contractible investments (e.g., Whinston, 2003).

The integration rationales should not only analyze ex ante arguments, but also consider the effects of ex post coordination and incentive structures particularly since they may create polarized perspectives. This dilemma was recognized by Holmström and Milgrom (1994) as they emphasize the need to align different internal incentive systems to avoid competing behaviors. Hence, the internal incentives from asset ownership, authority to direct work and weak incentives to avoid agents’ adverse selection should ideally all be complementary. This is because agents in distribution that are incentivized by segregated asset ownership are unlikely to care for the future value of the manufacturing assets, which may lead to undesirable and inefficient decisions. Therefore, each of the incentive elements should react in concert to the influences of exogenous conditions. If the effects from market transactions, that guide distribution’s prioritization of effort, cannot be observed because assets are plastic and thus subject to moral hazards, then manufacturing should integrate forward. This assumes that integration improves manufacturing’s ability to monitor the output of distribution efforts. But at the same time, integration should cause distribution to care about the manufacturing assets, thereby improving Pareto optimality.

While this has intuitive appeal, it also presents questions that need answers. First, we cannot assume that just because distribution efforts are not observable, they are not subject to moral hazard. Prioritization of efforts that to the manufacturer may look like moral hazard costs can easily reflect distribution’s use of idiosyncratic market knowledge used for future profits. This constitutes investment in intangible assets, exemplified by customer satisfaction and loyalty.

Second, well-meant yet weak incentives aimed at preserving the value of the manufacturing assets should not remove the incentives for distribution to prioritize customer satisfaction and

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loyalty. If a manufacturing firm integrates distribution that uses idiosyncratic resources to create value, then the internal structures and incentive systems should preserve these incentives.

Alternatively, the integrated company should align the incentives linked to different assets and resources so the marginal profits from integration and alignment are higher than is the case with segregated ownership. If integration does not resolve this and we observe segregated ownership of assets, then there will be inevitable conflicting interests between the two long-linked interdependent activities, e.g., manufacturing and distribution, which must be governed contractually.

Holmström and Milgrom (1994) were inspired by Anderson and Schmittlein’s (1984) study of forward integration. This study considered the high cost of monitoring performance from a moral hazard perspective and the effects of employee education and their willingness to perform non-selling activities from an asset specificity investment perspective. However, Holmström and Milgrom (1994) recognize the failure to explain similar examples of high monitoring cost with segregated ownership of assets. Adopting a property rights theory perspective on the non-contractibility of distribution’s non-selling (manufacturing important) activities will also lead to a forward integration decision. The reason is straight forward. If non-selling activities are considered important and present an investment incentive to manufacturing but not to distribution, the distributor will not undertake this investment due to lack of contractual protection of the future value. More precisely, distribution will only undertake the non-contractible investments if they are important and distribution remains the residual claimant to future value from ownership rights. Conversely, if investments in non-selling activities are important to manufacturing, forward integration will give them property rights to direct the distribution so they undertake these investments.

These polarized explanations make it relevant to ask if there are different and competing dimensions affecting the firms’ portfolio of activities and how this affects forward integration.

Does the activity that the distribution undertakes to ensure that the manufactured product stays competitive in the final product markets reflect a pure long-linked technology (Thompson, 1967)? Or does it (also) imply important elements of intensive adaptation to customer specific demands? Using the Holmström and Milgrom (1994) conception of the firm as an incentive system this would imply that for integration to be economical there would not be any ‘vertical’

competing dimensions affecting the activities of agents along the value chain.

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We now turn to the empirical evidence about the upstream and downstream activities undertaken in relation to forward integration.