Vertical Integration and the Distribution of Property Rights

Abstract

What is a firm? What are the determinants of how vertically integrated are the activities of the firm? This paper builds on the foundations laid by Coase (1937), Williamson (1979) and Klein et al. (1978) which emphasise the benefits of ‘control’ in response to situations where there are difficulties in writing or enforcing complete contracts.1 We define the firm as being composed of the assets (e.g. machines, inventories) which it owns. We present a theory of costly contracts which emphasises that contractual rights can be of two types: specific rights and residual rights. When it is too costly for one party to specify a long list of the particular rights it desires over another party’s assets, it may be optimal to purchase all the rights except those specifically mentioned in the contract. Ownership is the purchase of these residual rights of control. We show that there can be harmful effects associated with the wrong allocation of residual rights. In particular a firm which purchases its supplier, thereby removing residual rights of control from the manager of the supplying company, can distort the manager’s incentives sufficiently to make common ownership harmful. We develop a theory of integration based upon the attempt of parties in writing a contract to allocate efficiently the residual rights of control between themselves.