Fisher Body revisited: Supply contracts and - Amherst College

17 Pages·2006·0.19 MB·English

EurJLawEcon(2006)22:181–196
DOI10.1007/s10657-006-0310-7
Fisher Body revisited: Supply contracts and vertical
integration
AndreasRoider
(cid:2)C SpringerScience+BusinessMedia,LLC2006
Abstract The vertical integration of Fisher Body by General Motors has been a
leadingexampleinboththetransaction-costtheoryandtheproperty-rightstheoryof
thefirm.Thepresentpapermakesthefollowingcontributions.First,weshowhowa
simpleextensionoftheproperty-rightstheoryofthefirm(whichallowsforcontractible
trade) is able to rationalize the observed ownership arrangements, supply contracts,
and investment behavior both before and after integration. Second, the model lends
supporttoKlein’s(2000)viewthatanincreaseindemandforclosedautomobilebodies
waspivotalforverticalintegration.
Keywords Verticalintegration.Supplycontracts.Hold-up.Propertyrights.
Boundariesofthefirm
JELClassification L22.L24.L14.K12
Inhisclassicarticleon“TheNatureoftheFirm”Coase(1937)askedthefundamental
questionofwhatdeterminestheboundariesofthefirm.Whyisitthat,eventhough
markets are in general thought to allocate resources efficiently, a large fraction of
economic activity takes place insight firms? In particular, which forces determine
whether a certain transaction is conducted via the market or insight the firm (e.g.,
throughanemploymentrelationship)?Bynow,Coase’thought-provokingquestions
haveinspiredavastliteratureontheboundariesofthefirm.Boththeearliertransaction-
costtheory(seee.g.,Kleinetal.,1978;Williamson,1975,1985)andthelaterproperty-
rightstheoryofthefirm(seee.g.,GrossmanandHart,1986;HartandMoore,1990;
Hart,1995)haveprovidedvaluableinsightsinintegrationdecisionsoffirmsandhave
beenappliedwidely.
A.Roider((cid:2))
UniversityofBonn,WirtschaftspolitischeAbteilung,Adenauerallee24-42,53113Bonn,Germany
e-mail:[email protected]
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182 A.Roider
Given the relative scarcity of data, case studies have played an important role in
studyingquestionsofverticalintegration.1Inparticular,theFisherBody-GeneralMo-
torscasehasachievedsignificantprominenceintheliterature.Thiscase,firstdiscussed
byKleinetal.(1978),concernstherelationshipbetweenFisherBody(hereafter,FB),
a supplier of automobile bodies, and General Motors (hereafter, GM), a carmaker.2
Whilefrom1919till1926thetwofirmshadoperatedunderanexclusivesupplycon-
tractthatobligedGMtobuyallofitsautomobilebodiesfromFB,in1926theparties
decidedonfullverticalintegrationofFBbyGM.Bothinthetransaction-costtheory
andtheproperty-rightstheoryofthefirmtheFisherBodycasehasbeentheleading
exampletohighlightissuessuchasassetspecificity,relationship-specificinvestments,
exclusive contracts, and vertical integration. For example, the Fisher Body case has
beendiscussedintheinfluentialbooksbyWilliamson(1985)andHart(1995),andin
avarietyofothereconomicsandbusinesstextbooks,suchasTirole(1988),Milgrom
andRoberts(1992),CarltonandPerloff(1994),Ricketts(1994),Salanie(1997),and
Besankoetal.(1996).Thecontinuedprominenceofthecaseiswitnessedbyanum-
ber of articles, such as Crocker and Masten (1996), Bolton and Scharfstein (1998),
HolmstromandRoberts(1998),RajanandZingales(1998),andSegalandWhinston
(2000). More recently, there has been a renewed intense debate regarding the facts
andinterpretationoftheFisherBodycase(seee.g.,Casadesus-MasanellandSpulber,
2000; Coase, 2000; Freeland, 2000; Klein, 2000), to which we will return in more
detailbelow.
GiventheprominenceoftheFisherBodycase,itisthemoresurprisingthatthere
doesnotseemtoexistaformalanalysisthatisexplicitlytailoredtothiscase.Inpartic-
ular,theredoesnotseemtobeacomprehensiveexplanationofwhyinitiallytheparties
deemedseparateownershipinconjunctionwithanexclusivesupplycontractoptimal,
whilelateronthepartiesdecidedtointegratevertically,whichwasaccompaniedbythe
lackofanycontractualsupplyprovisions.3Sofar,theliteraturehasmostlyfocussedon
thechoiceoforganizationalform.Forexample,Kleinetal.(1978)postulatethathold-
upproblemsaremitigatedwithinfirms.4Theyarguethatafteraconsiderablechangein
demandconditionsFBheldupGMbyrefusingtomakenecessaryinvestmentsinpro-
ductioncapacitysuchthatintheendverticalintegrationbecamenecessary.Similarly,
Hart(1995)arguesthatGMverticallyintegratedtoinsureabetterbargainingposition
inthefuture.Theliteratureis,however,relativelysilentaboutwhatexactlyrendered
theinitialsupplycontractregimeinferior.“WhydidGMandFisherBodynot[just]
writeabettercontract”afterdemandconditionshadchanged,asCasadesus-Masanell
and Spulber (2000, p. 75) reasonably ask? Clearly, one could take the position that
(given the practical impossibility of complete-contingent contracts) any contractual
arrangementwasevenmorepronetohold-upproblemsand,throughintegration,the
1Foranoverviewoverevidenceonthetransaction-costandproperty-rightstheoriesofthefirm,seee.g.,
Whinston(2001).
2InanumberofsubsequentarticlesKleinhaselaboratedonhisinitialdiscussionoftheFisherBodycase
(seee.g.,Klein,1988,1996,1998,2000).
3Notethatsuch“insidecontracting”isnotuncommoninotherinstances(seee.g.,HolmstromandRoberts,
1998).
4Partieswhomakerelationship-specificinvestmentsarelikelytobesubjecttohold-upbytheirtrading
partnerifcontractscanonlybeincomplete;resultinginsuboptimalinvestmentincentives.
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FisherBodyrevisited:Supplycontractsandverticalintegration 183
partiesfinallyabandonedthisinferiorregime.However,suchanexplanationremains
unsatisfactory: both GM and FB were established, sophisticated businesses, and it
seemsunlikelythatasuboptimalgovernancestructurecouldhaveprevailedforsuch
alongtime(orhavebeeninstalledinthefirstplace).
WhileamorethoroughunderstandingoftheFisherBodycaseseemstobedesirable
initsownright,itisalsointerestingfromamoregeneralperspective.Arguably,abetter
understandingofhowsupplycontractsandthechoiceoforganizationalforminteract
seemstobenecessarytoanswerCoase’(1937)initialquestionwhysometransaction
areconductedinmarkets,whileothersareconductedinsidefirms(seeHolmstromand
Roberts,1998,foranargumentalongtheselines).Abetterunderstandingofthisissue
would also help to shed light on a controversy between Coase and Klein (see e.g.,
Coase,1988,2000;Klein,1988,2000),whohavedebatedunderwhichcircumstances
largespecificinvestmentsandassetspecificityindeednecessitateverticalintegration:
in contrast to Klein, Coase asserts that asset specificity problems can in general be
handledcontractuallywithouttheneedforverticalintegration.
Thepresentpapermakesthefollowingcontributions.First,weshowthatasimple
extensionofaproperty-rightsmodelthatallowsfortradebetweenthepartiestobecon-
tractibleisabletorationalizetheobservedownershiparrangements,supplycontracts,
investmentbehavior,aswellastheregimeswitchin1926.Inparticular,wediscussin
detailhowoptimalinitialarrangementswereinfluencedbytheparties’benefitsfrom
residual control and the benefits from investments. In our model the magnitude of
thesebenefitsinitiallyimpliedtheoptimalityofseparatefirms,whilelateronvertical
integrationbecamenecessary.Second,themodelprovidessupporttoKlein’s(2000)
viewthattheinitialcontractualsolutionwasoptimal,butthatFB’srefusaltoinvest
inanewplant(subsequenttoasubstantialincreaseindemandforclosedautomobile
bodies) made full vertical integration of FB by GM desirable. While Klein (2000)
arguesinformallythatthechangeindemandconditionspushedtheinitialsupplycon-
tract regime outside its “self-enforcing range”, he remained unsure what exactly it
was“aboutthelarge,unexpecteddemandincreasebyGMthatcausedFishertotake
advantageoftheimperfectbodysupplyregime.”5 Oursimplestaticmodelsuggests
thatthechangeindemandconditionsworsenedFB’sinvestmentincentivesandmade
aswitchtoaregimethatmaximizedGM’sinvestmentincentivesdesirable.
Inourformalanalysis,weextendastandardproperty-rightsmodel(seee.g.,Hart,
1995).Weassumethatinadditiontotheownershipstructureoveranasset(e.g.,FB’s
physical capital), the parties can sign supply contracts specifying trade quantities
and transfer payments. The ownership structure determines who has residual rights
of control over the asset. In line with the property-rights literature, we assume that,
throughrenegotiations,thepartieswillalwaysagreeonanex-postefficientoutcome.
Hence,theinitialownershiparrangementandsupplycontractonlyserveasthreatpoint
in these renegotiations. That is, they determine the parties’ bargaining positions. In
ordertocapturetheobservationthatsomeoftheinvestmentshavebeenmadebyFB,
while others have been made by GM, we assume that the parties make transferable
investmentsinphysicalcapital(e.g.,anewplant),whereonlythetotalamountinvested
matters. This will imply that in equilibrium only one of the parties invests, where
5Klein(2000,p.129).
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184 A.Roider
the identity of the investing party will, however, depend on the underlying market
conditions.Whentradingwitheachother,bothpartiesprofitfromabetterasset.As
the investor does not take this positive externality fully into account, investments
underanycontractwillfallshortoftheirefficientlevel.Asaconsequence,anoptimal
initial arrangement maximizes the investment incentives of one of the parties. We
argue that, as initially residual rights of control were of moderate importance for
GM and investments had mainly cost-reducing effects, in the early period of their
relationshipitwasoptimalforthepartiestomaximizeFB’sincentivetoinvest.This
wasachievedthroughseparatefirmsandanexclusivesupplycontractbecausesuchan
arrangementprovidedFBwithastrongpositioninlaterbargaining.However,afterthe
substantialincreaseindemandforclosedautomobilebodiesGMwouldhavebenefited
substantiallymorefromFB’sinvestmentsthanbeforetheincrease.Asaconsequence,
GMwouldhavebeenabletoappropriateasubstantiallyhighershareoftheinvestment
returnthroughrenegotiations;therebydeterioratingFB’sincentivetoinvest.Dueto
these changes in the underlying market conditions, the model suggests that now it
was desirable to provide GM with maximal investment incentives. That is, through
verticalintegrationandtheabsenceofanyobligationtopurchasefromFBtheparties
maximizedGM’sbargainingposition(inexchangeforasidepaymenttoFB).
Some caveats are in order. First, any formal analysis necessarily abstracts from
someoftherelevantissues.AsKlein(2000),weemphasizeresidualcontrolrightsand
investmentsinphysicalcapital.However,otherauthors,suchasCasadesus-Masanell
andSpulber(2000),Coase(2000),andFreeland(2000),haveputmoreemphasison
otherissuessuchastheneedtosecureaccesstotheFisherbrothers’specifichuman
capital or coordination problems as driving forces behind the decision to integrate.
While we do not deny that such considerations will also have played a role, we
follow Klein (2000) in arguing that FB’s refusal to invest in a new plant seems to
havebeenpivotal(foramoredetaileddiscussion,seeSection1below).Second,the
property-rightstheorymakesthesimplifyingassumptionoftakingthefirmasasingle,
unified,rationaldecisionmaker.6Thereby,itobviouslyabstractsfromwhatmightbe
important issues, such as agency problems within firms, decision making by teams,
boundedrationality,andbehavioralissues.7However,wethinkitisinterestingthatour
simpleextensionofaproperty-rightsmodelisneverthelessabletoreplicateimportant
stylizedfactsoftheFisherBodycase.
Theremainderofthepaperisstructuredasfollows.InSection1wepresentabrief
accountoftheFisherBodycaseandsubsequentlydiscusshowithasbeeninterpreted
in the literature. Section 2.1 introduces the model, and in Section 2.2 we show that
thismodelisabletoshedlightontheFisherBodycase.Section3concludes.
6Moredetaileddiscussionsofvariouscriticismsthathavebeenraisedagainsttheproperty-rightstheoryof
thefirmare,forexample,tobefoundinBoltonandScharfstein(1998)andHolmstromandRoberts(1998).
Forarecentsurveyonbehavioralorganizationaleconomics,seee.g.,CamererandMalmendier(2005).
BasedonCohenetal.(1972),Gibbons(2003)discusseshoworganizationaleconomicsmightprofitfrom
incorporatingsociologists’insightsonorganizationalbehavior.
7Forexample,itisgenerallyacknowledgedthatFB’sbehaviorhadtoacertaindegreealsobeeninfluenced
bytheFisherbrothers’desiretobetreatedasaunit,theirattachmenttothefamilybusiness,andtheir
valuationofindependence.
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FisherBodyrevisited:Supplycontractsandverticalintegration 185
1 TheFisherBody-GeneralMotorsrelationship
ConsiderableefforthasbeenexpendedtounearththefactsunderlyingtheFisherBody
case. Subsequent to the initial discussion in Klein et al. (1978), an intense debate
regardingthefactsandinterpretationofthecasehasensued,andexactlybecausethis
debate has been controversial, a rather detailed account of the relationship between
FisherBodyandGeneralMotorsisavailable(seee.g.,Kleinetal.,1978;Coase,1988,
2000; Klein, 1988, 2000; Casadesus-Masanell and Spulber, 2000; Freeland, 2000).
Most of the evidence on the relationship between Fisher Body and General Motors
stems from an antitrust case brought by the United States Department of Justice in
1949againstthe1917–19acquisitionbyDuPontof23%oftheGMvotingcommon
stock.8
Inthefollowing,inSection1.1wefirstpresentanoverviewovertheFisherBody
case,wherewerestrictattentiontothemainevents.9Subsequently,inSection1.2we
brieflydiscusshowtheFisherBodycasehasbeeninterpretedintheliterature.
1.1 TheFisherBodycase:Anoverview
Prior to 1919, automobiles mostly exhibited individually constructed, open, largely
woodenbodies.However,by1919productionprocesseshadbeguntoshifttowards
technologicallymoredemandingcomposite(woodframedandmetalskinned)closed
bodies.10 HavingbeenfoundedbytheFisherbrothersin1908,andhavingproduced
closed bodies as early as 1910, by 1919 the Fisher Body Corporation was a very
successfulbusiness.11Itwasthelargestproducerofautomobilebodiesintheindustry
buildingautomobilebodiesforallleadingautomobilemanufactures.Inthesubsequent
descriptionoftherelationshipbetweenFisherBodyandGeneralMotorsitturnsout
tobeusefultodistinguishanearlyperiodfrom1919through1924andalateperiod
from1925through1926.
Earlyperiod(1919–1924).ThecontractFisherBodyandGeneralMotorssignedin
1919containedthreemainprovisions12:
1. The first part was an exclusive supply provision. For a horizon of ten years it
obliged GM to buy all its closed automobile bodies from FB. However, FB was
freetoadditionallytradewithothercarmakers.
2. GM acquired a 60% interest in FB. The parties signed an agreement that put the
shares acquired by GM in a voting trust. Unanimity was required for the trust to
8Referencestotheoriginalsourcescanbefoundinthearticlescitedabove.
9ThisoverviewismainlybasedonKlein(2000),whoalsoprovidesdetaileddiscussionsofthecriticisms
raisedbytheotherarticlescitedabove(seealsoSection1.2below).
10White(1991)providesanintroductionintoautomobileproductionprocessesinthe1920’sanddiscusses
thehistoryoftheFisherBodyCorporation.
11AsCoase(2000,p.19)putit,“thetaleofFisherbodyisthetaleoftheFisherbrothers,”whowere
runningthecompany.FisherBodywasfoundedbyFredandCharlesFisher(alongwithanuncle),and
fourotherbrothersjoinedthecompanyandassumedoperatingpositions.Twooutsiders,LouisandAaron
Mendelssohns,providedearlyfinancialbacking(seeCasadesus-MasanellandSpulber,2000).
12Seee.g.,Coase(2000).
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186 A.Roider
80
70
60
50
nt
ce 40
er
p 30
20
10
0
1920 1921 1922 1923 1924 1925 1926
Fig.1 Industryshareofsalesthatwereclosedbody
voteitssharesonanyaction,andoneoftheFisherbrothers,FredFisher,wasone
ofthefourtrustees.
3. ThesixFisherbrotherssignedemploymentcontractswithFisherBody.13
As both Coase (2000) and Klein (2000) confirm, the unanimity provision in the
votingtrustagreementimpliedthat,despiteGM’s60%interest,FBwasrunasaninde-
pendentfirm.14 Moreover,theemploymentcontractsimpliedthattheFisherbrothers
werealsoinoperationalcontrolofFB.InordertoproduceGM’sclosedbodiesFBhad
tomakelargerelationship-specificinvestmentsinplantsandequipment,15andduring
thisearlyperiodtheinitialcontractualsolutionseemstohaveworkedwell.Until1924
FisherBodybuiltorpurchased14assemblyplants,and12ofthoseplantswerelocated
nearGMproductionfacilities.Notably,duringtheseearlyyearsthemarketenviron-
mentprovedrelativelystableand,presumably,didnotevolveinawaydramatically
differentfromwhatthepartieshadanticipatedin1919.Inparticular,GM’ssalesover
theentire1919–1924periodgrewbyonlyabout50%,andtheshareofindustrysales
thatwereclosedbodyamountedto17%in1920and34%in1923(seeFig.1above).16
Late period (1925–1926).In contrast to the stable market conditions of the early
period,thelateperiodfrom1925till1926witnessedconsiderablechange.GM’ssales
grewveryrapidly,andFig.1illustratesthattherewasanacceleratingshiftfromopen
13ShortlybeforeexpirationonOctober1,1924theseemploymentcontractswereextendedtill1929(see
e.g.,Klein,2000).
14Obviously,thisraisesthequestionwhyGMindeedacquiredthe60%interest.First,fromaproperty-
rightstheoryperspective,thistransfercouldbeinterpretedasanex-ante“side-payment”fromGMtoFB,
where,throughex-antebargaining,thepartiesallocatedsomeofthe(expected)surplusoftheirrelationship
toFB(seealsoFootnote27below).Second,Freeland(2000)hasarguedthatthisacquisition(aswellas
thelaterfullintegration)mightalsohaveserveddefensivepurposes,i.e.,itmighthavebeenintendedto
precludeFBfromanyfutureintegrationwithsomeothercarmaker,suchasFord.
15Thecompositeclosedbodiesofthetime(woodframedandmetalskinned)requiredsubstantiallyhigher
specificinvestmentsthantheearlierlargelywoodenopenbodies,and“largesumsofcapitalwereneeded
tomakeuniquediesforeachmetalpanelrequired,andhugefacilitieswereneededtostorebodieswhile
paintandvarnishdried”(White,1991,p.50f.).
16ThesedataaretakenfromSloan(1964,p.152and214).
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FisherBodyrevisited:Supplycontractsandverticalintegration 187
toclosedautomobiles.ThenumberofvehiclesproducedbyGeneralMotorsroseby
42%in1925and48%in1926,andtheindustryshareofsalesthatwereclosedbody
jumpedto43%in1924,56%in1925,and72%in1926.17 Asaconsequence,inthis
lateperiodFB’sclosedbodysalestoGMgrewbyabout200%.
At the same time (and in contrast to the early period), FB refused to build or
acquire new plants near GM’s facilities. In particular, FB refused to invest in an
importantnewplantclosetotheGMBuickfacilitiesinFlint,Michigan.18 AsGM’s
chiefexecutiveofficerofthetime,AlfredP.Sloan,putit:“theFisherbrothers,who
werereallyoperatingtheFisherBodyCompanyinthosetimes,ratherquestionedthe
desirability of their putting up large amounts of capital to establish these assembly
plants in conjunction with the GM assembly plants”.19 The failure to make these
investmentsresultedinGMexperiencingbodyshortagesthatultimatelyforceditto
reducescheduledproduction.Asaconsequenceoftheseproblems,Sloanconcluded
thatfullverticalintegrationofFisherBodyin1926was“notaquestionofanything
but a must.” And indeed, following first boardroom discussions in February 1925,
theverticalintegrationofFisherBodybyGeneralMotorswasfinalizedonJune30,
1926.OntheverynextdayGeneralMotorsannouncedthatitwouldcreatetheFlint
body-buildingfacilityitself.
1.2 TheFisherBodycaseintheliterature
Asdiscussedabove,therehasrecentlybeenanintensedebateregardingthefactsand
interpretation of the Fisher Body case, and the original description of the case by
Kleinetal.(1978)hasbeenchallenged(seee.g.,Coase,2000;Casadesus-Masanell
andSpulber,2000;Freeland,2000).20 Inreply,Klein(2000)setsouttorefutethese
criticismsandmaintainsthatverticalintegrationwasmeanttosolveahold-upproblem
that the parties faced. In the following, we briefly summarize both Klein’s (2000)
view and the alternative interpretations on offer. For more detailed accounts of this
controversy,theinterestedreaderisreferredtotheabovecitedarticles.
17Again,seeSloan(1964).
18On the one hand, GM preferred plants close to its production facilities because they implied lower
transportationcosts.Ontheotherhand,byaddingoperationsinDetroit(ratherthaninvestinginFlint)FB
wouldhavebeenabletobetterserveothercustomers,suchasChrysler.However,itisimportanttonote
thatFB’srefusaltoinvestclosetoGMfacilitiesonlyaroseafter1924,andKlein(2000)assertsthataFlint
plantwouldclearlyhavemaximizedthejointprofitofGMandFB.Hence,forsimplicity,intheformal
modelwewilltreattheparties’investmentsasone-dimensionalratherthantwo-dimensional(locationand
magnitude).
19BoththisquotationandtheonebelowaretakenfromKlein(2000,p.114).Duringtheearlyperiod(1919–
1924)FBhadmainlyusedproceedsfromitssaleofsharestoGMtobuildorpurchasevariousassembly
plants.WhileCoase(2000)andFreeland(2000)arguethattheFlintplantepisodemainlyrepresenteda
disagreementoverfinancing,Klein(2000)arguesthatthisisunlikelyfortworeasons.First,atthesame
timeFBmadeinvestmentsinbodycapacityforothercustomers(e.g.,Chrysler).Second,ifFB’srefusalto
investintheFlintplantwouldmerelyhavebeentheresultofacapitalshortage,GMcouldhaveovercome
thisproblembyprovidingaloantoFBforthecapitalcosts,asithaddoneonatleastthreeoccasionsinthe
past(seeKlein,2000,p.110ff.).
20BothCoase(2000)andFreeland(2000)mainlyagreewithKlein’s(2000)descriptionofevents,butdiffer
intheirinterpretation.
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188 A.Roider
Klein(2000)agreeswithCoase(2000)thatassetspecificityinitselfisingeneral
insufficient for vertical integration to be desirable. In particular, he argues that it is
unlikelythatthepartiesenteredtheinitialsupplycontractregimebymistake.Rather
itseemstobethecasethatinitiallythepartiesdeemedanexclusivedealingcontract
sufficient to protect them against hold-up. Klein (2000) argues that the substantial
increaseindemandforclosedbodiesduring1925–26gaveFBleverageoverGMand
led FB to take advantage of GM’s weak position. FB’s refusal to invest in the Flint
plantprovedratherharmfulforGM.Toexplainthisbehavior,Klein(2000)arguesthat,
due to insufficient reputational capital, the rise in demand shifted the initial supply
contractoutsideits“self-enforcingrange”,andverticalintegrationbecamenecessary.
Incontrast,Coase(2000)deniesthathold-upplayedaroleintheverticalintegration
ofFisherBody.Inparticular,hetakesthefactthatintheearlyperiodFBhadinvested
in various new plants as evidence that investment problems were not pivotal in the
decisiontointegrate.RatherheholdstheviewthatGMwasunsatisfiedwiththe1919
agreement because it had brought about a long-term relationship with FB that was
unsatisfactoryinthesensethattheFisherbrotherspaidinsufficientattentiontoGM’s
needs. Hence, GM’s aim was to bring the Fisher brothers (whose specific human
capitalwasdeemedimportant)inacloserrelationshiptoimprovecoordination.And
as the “trial marriage” of the initial regime proved a success for both parties, they
finallyagreedtofullyintegrate.21
Finally, in a similar spirit, Casadesus-Masanell and Spulber (2000) and Freeland
(2000)alsoemphasizetheneedtosecureaccesstotheFisherbrothersandcoordination
issuesasthedrivingforcesbehindverticalintegration(seealsoChandlerandSalsbury,
1971).
2 Optimalcontractsandthedemandforclosedautobodies
In this section, we present a simple extension of the property-rights theory of the
firm, where the main stylized facts of the Fisher Body case emerge as equilibrium
phenomena.Followingthediscussionabove,thesestylizedfactsmaybesummarized
asfollows:
1. From1919till1926FBandGMoperatedastwoseparatefirms,whereanexclusive
supplycontractwasinplacethatobligedGMtobuyallofitsautomobilebodies
fromFB.Duringthisperiod,FBinvestedinseveralnewplantstomeetGM’sneeds.
2. After a substantial increase in demand for closed automobile bodies and FB’s
subsequent refusal to invest in an important new plant, the parties agreed on full
vertical integration of FB by GM in 1926, after which GM built the plant itself.
Afterverticalintegrationnoexplicitsupplycontractwasinplace.
Klein’s (2000) analysis suggest that, while other factor (such as human capital
specificity, market trends, etc.) will clearly also have played a role, the dramatic
increaseindemandforclosedautomobilesintheperiod1925–26seemstohavebeen
21Coase(2000)reportsthat,whilevisitingGeneralMotorsin1932,hewastoldthatthereasonforvertical
integrationwastoensurethatFisherBody’splantswerelocatedclosetoGeneralMotors’facilities.However,
hedeemsthisclaimunlikely.
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FisherBodyrevisited:Supplycontractsandverticalintegration 189
pivotalforthedecisiontointegratevertically.ThesimplemodelbelowsupportsKlein’s
(2000) view, but the mechanism at work does not rely on the reputational concerns
emphasizedbyKlein(2000).
2.1 Asimpleproperty-rightsmodelofsupplycontractsandverticalintegration
Basicstructure.Considerthefollowingsimpleextensionofastandardproperty-rights
model (see e.g., Hart, 1995) that allows to simultaneously discuss the issues of the
boundariesofthefirm,supplycontracts,andchangesintheidentityoftheinvesting
party. A downstream buyer B (e.g., General Motors) wants to procure a variable
quantityofaninput(e.g.,automobilebodies)fromanupstreamseller S (e.g.,Fisher
Body), where B and S are assumed to be risk-neutral and symmetrically informed.
Twoorganizationalformswillbeconsidered:BandSmayeitherbeseparatefirmsor,
alternatively,theremaybeanintegratedfirminwhich Bprocurestheinputinternally
from S. Formally, we assume that there is an asset A (e.g., Fisher Body’s physical
assets)andtwopossibleorganizationalforms O.Specifically,theasset Amayeither
beownedbytheseller(i.e.,O = S)orbythebuyer(i.e.,O = B),whereinlinewith
theliterature(seee.g.,Whinston,2001)theformercaseisinterpretedasseparatefirms,
whilethelattercaseisinterpretedasintegration.Theorganizationalformdetermines
whohasresidualrightsofcontrolover A.Thatis,theorganizationalformdetermines
whichofthepartiescandecideaboutalternativeusesoftheassetnotspecifiedinan
initial contract. The benefits from such residual control rights will be discussed in
moredetailbelow.
Beforeactuallytradingthepartiesmaysimultaneouslymakerelationship-specific
investmentsiBandiSinordertoincreasethevalueoftheasset(e.g.,bybuildinganew
plant),whereiB,iS ≥0.Asdiscussedabove,inordertobeabletostudychangesinthe
identityoftheinvestingparty,weassumethatB’sandS’sinvestmentsaretransferable
inthesensethatthevaluea oftheassetonlydependsonthetotalamountinvested.
Formally, the value of the asset is given by a(i), where i =iB +iS.22 Indeed, Hart
(1995)hasarguedthatformanyinvestmentsinphysicalcapitalitwillnotmatterwhich
ofthepartiesactuallyinvestsbecausesuchinvestmentsarefrequentlynotspecificto
aparticularparty.Transferabilityofinvestmentswillimplythatingeneralonlyoneof
thepartiesinvestsinequilibrium,butthatdependingonthecircumstancesitmayeither
be B or S whoinvests.Inlinewiththeproperty-rightstheoryofthefirmweassume
thatinvestmentsareobservabletotheparties,butthattheyarenon-contractible.23As
discussedabove,thelargeincreaseindemandin1925–26wasarguablyunexpected,
andhenceitconstitutesanunforeseenshiftinunderlyingparametersratherthanthe
realizationofaforeseenstateoftheworld.Forthisreason(andasitwouldnotadd
anyadditionalinsights)wedonotexplicitlyintroduceuncertainty(e.g.,regardingthe
effectsofinvestmentsonthepayoffsoftheparties).However,themodelcouldeasily
begeneralizedinthisdirection.
22To simplify the analysis we assume that investment costs are equal to iB and iS, respectively, a is
satnrdicltilmyii→nc∞rea∂sa∂i(ini)g=an0d.concave,0<a<1,and(inordertoensureinteriorsolutions)limi→0 ∂a∂(ii) =∞
23Thisassumptionissupportedbytheobservationthatinthelateperiodof1925–26theFlintplantbecame
suchanissue,whichwouldpresumablynothavebeenthecasehadinvestmentsbeencontractible.
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190 A.Roider
Theconsideredtimingisasfollows.Atadate0thepartiessignaninitialcontract
(O,q,t) specifying the organizational form O, a trade quantity q ∈[0,1] that B
procuresfromS,andatransferpaymenttfromBtoS.24Hence,thestandardproperty-
rights model is only augmented in that trade between B and S is assumed to be
contractible.Subsequently,atdate1thepartiesinvest.Theinitialcontractispossibly
renegotiatedatdate2,andfinallytradetakesplaceandpaymentsaresettledatdate3.
Renegotiationsarediscussedinmoredetailbelow.25
Payoffsoftheparties.Ifrenegotiationsatdate2weretofail,thepartieswouldobtain
thefollowingpayoffsfromexecutingtheinitialcontract.First, B andSwouldderive
payoffsfromtradingthecontractuallyspecifiedquantityq internally.Forsimplicity,
weassumethat,conditionaloninvestments,theseller’smarginalcostofproduction
andthebuyer’smarginalvaluationoftradeareconstant.Inparticular,weassumethat
theseller’scostofproductionaregivenbyq·σ ·[1−a(i)],andthatthebuyerderives
abenefitq·β·a(i)fromprocuringquantityq fromtheseller.Asbothpartiesprofit
fromamorevaluableassetwhentradinginternally,investmentshavetwodirecteffects:
atthesametime,theyreducetheseller’scostofproductionandincreasethebuyer’s
valuation of trade. The variables σ and β are parameters that are meant to capture
potentialdifferencesintheresponsivenessoftheparties’payoffstoinvestments,where
σ,β >0.Second,thepartiesmayderivebenefitsfromresidualrightsofcontrolover
the asset. These benefits from residual control depend on the organizational form
specifiedintheinitialcontract.Thatis,theorganizationalformdetermineswhichof
thepartieshastherighttodecideonalternativeusesoftheasset.Forexample,while
GMclearlywasitsmostimportantcustomer,priortointegrationFBhadthefreedom
tosupplyothercarmakersaswell(anddidso).However,suchexternaltradedidnot
takeplacesubsequenttointegration.Consequently,weassumethattheownerofthe
assetderivesthefollowingbenefitsfromhavingresidualrightsofcontrol:inthecaseof
separatefirms,Sderivesacontrolbenefits·a(i),whileinthecaseofanintegratedfirm,
Bobtainsacontrolbenefitb·a(i),wheres,b>0.Asabove,thebenefitsfromcontrol
are the larger, the more has been invested. To summarize, for given contract terms,
thethreatpointpayoffofthesellerisgivenbyπS =t −q·σ ·[1−a(i)]+s·a(i)if
24Whensigningtheircontractin1919,FBandGMalsoagreedtosetthepriceofautomobilebodies
equaltoFB’svariablecostplus17.6percent,whichwasmeanttoensurereasonablepricing.Inthelate
periodoftheirrelationshipGMalsobecamedissatisfiedwiththisformula,butFB’srefusaltoinvestinthe
Flintfacilityseemstohavebeenthemorepressingproblem(seee.g.,Klein,2000;Freeland,2000).Ifthe
payoffsofbothFBandGMwouldhavebeenfullyverifiablebyacourt,itwouldinprinciplehavebeen
possibletomakeFBresidualclaimantonanyreturnsfromitsinvestment.However,fromapracticalpoint
ofview,suchfullverifiablilityseemstobehighlyunlikely,andthiscontentionissupportedbythefactthat
inthe1919contractitwasspecifiedthattherewouldbecompulsoryarbitrationintheeventofanydisputes
regardingprice.Asaconsequence,wemakethesimplifyingassumptionthatonlyfixedtransferpayments
arepossible.
25Givenadditionaltechnicalassumptionsitcanbeshownthatthepartiescannotgainfromconsidering
morecomplicatedcontracts(e.g.,optioncontracts),wherethecontractterms(i.e.,theorganizationalform,
thetradequantity,andtransferpayments)arefunctionsoflatermessagesoftheparties(seeRoider,2004).
Thispapermoregenerallydiscussestheissuesofassetownershipandquantitycontracts.Itis,however,not
tailoredtotheFisherBodycase,andconsequently,incontrasttothepresentpaper,itdoesnotdiscussthe
preciseconditionsthatledtotheoptimalityofseparatefirmsrespectivelyverticalintegrationintheFisher
Bodycase.
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