Vertical Restraints/contracts

1
Vertical Restraints/contracts try to replicate
the outcome of vertical integration

• Non-linear pricing, p and fixed fee
• Exclusive dealing or exclusive territories
• Franchising
• Profit sharing or revenue sharing
• Quantity forcing or quantity rationing
• Legal issues on vertical restraints
• Take away not ok when foreclosure an issue,
  otherwise a per case
• for example exclusive territories allowed if
  that is the only way the retailers provide
  services, if compete very aggressively in all
  territories no mark-up to provide services

2
Make versus buy

• Benefits of making benefits of buying
• Assure supply efficiency
• Avoid regulation less managerial burden
• Increase profits (DM)
• Agency theory, incentive alignments
• Price Discrimination
• Reduce transaction costs (Williamson)

3
Transaction costs

• When transaction costs are high there is the
  opportunity for opportunistic behavior.
• One case opportunistic behavior may arise is when
  there is a need for specific assets
• And the fact that contracts are incomplete.
• NOTE To be fair, the other main stream of lit to
  explain make versus buy decisions has to do with
  Agency theory, (the existence of moral hazard),
  hence leading to certain vertical relationships
  existing to provide better marginal incentives
  (Laffont and Martimor, for survey etc) well
  focus here on TC.

4
Transaction costs

• For example, upstream firm may invest in assets
  that are valuable only in relationship with a
  certain downstream firm. These assets are
  otherwise useless.
• The upstream firm is at mercy of downstream firm
  if she invests in those assets, so she may not
  want to invest
• So maybe if upstream firm engages in downstream
  production herself, those useful investments will
  then be made.
• Firms engage in vertical integration (longer term
  contracts) when purchasing in the spot market
  makes them vulnerable to opportunistic behavior
  Joskow takes this literally to data

5
Contract Duration and Relation Specific
InvestmentsEmpirical Evidence from Coal Markets

• By Paul Joskow, 1985, in American Economic
  Review
• Classic paper

6
Research question

• Are relation specific investments determinants of
  the contract length (duration) between coal
  suppliers (mines) and electric utilities
  (downstream buyers of upstream mines)?
• Assumption Risk aversion is not an important
  determinant of the structure of vertical
  relationships in this industry

7
Data

• Cross-section for year 1979
• 277 observations of coal vertical contracts
• Cross-sectional variation in contract length in
  the data
• 15 vertically integrated mines and utilities
• 15 spot market transactions
• 70 contracts with length between 1 and 5 years

8
Williamson (1983)s variables of interest in
coal-utility vertical relationships

• Site specificity
• Physical asset specificity
• Dedicated assets
• Human asset specificity
• Left hand side
• Contract duration time agreed ex-ante to abide
  btw parties

• -gtVariables defined as RHS determinants of
  contract length fro the empirical analysis
• Mine mouth
• Regional dummy
• Annual quantity

9
LHS duration

• -gtVariables defined as RHS determinants of
  contract length fro the empirical analysis
• OLS Estimates (Table 3)
• A Mine mouth plant has contract length predicted
  to be 16 years longer than those contracts of
  other plants
• Regional location matters, and east coast
  contracts have 3-5 shorter duration than west and
  mid west
• If Annual quantity contracted increases by an
  extra 1 million tons leads to 13 year increase in
  contract duration
• Shows evidence that indeed there exist
  appropriable quasi-rents associated with asset
  spec, site specif, etc in transactions between
  coal mines and utilities, and more for coal mines
  and mine mouth power plants (site specific)

10
Take away

• Buyers and sellers make longer ex-ante
  commitments (longer contracts) when relation
  specific investments are more important and rely
  less on repeated spot negotiations over time
• East Coast spot market, lots of mines,
  homogenous coal, better railroad system
• West Coast market power, coal not homogeneous,
  longer term contracts

11
Evidence of Relation specific investments as
determinants of vertical relationships in
Motion picture industry , Chisholm,1996

• Actors were long term employees before (Golden
  Age of Studio 1929-48), why not now?
• Paramount Case
• Role of TV
• Ask about contemporaneous anecdotal evidence on
  cross-sectional human asset specificity, type
  casting and correlation with and Oscars ?

12
Evidence of Relation specific investments as
determinants of vertical relationships in
Trucking Industry, Hubbard, 2000

• What explains the ownership structure?
• Role of on board computers?
• Human capital or asset specificity?
• Agency theory?