Topic 1:Property Right Approach

After skimming through the abstract and conclusion points of the listed material for the first topic The Property Rights Approach, I chose the famous book Firms, Contracts, and Financial Structure for further study. This book provides a framework for thinking about economic relationships and institutions such as firms. The basic argument is that in a world of incomplete contracts, institutional arrangements are designed to allocate power among agents. It points out that traditional approaches such as the neoclassical, principal?

agent, and transaction costs theories cannot by themselves explain firm boundaries. And describes a theory—the incomplete contracting or property rights approach—based on the idea that power and control matter when contracts are incomplete. As far as I see, neoclassical theory, views the firm mainly in technological terms. A single-product firm is represented by a production function and is trying to maximize profit under the constraint of technology and market. But it ignores all incentive problems and the internal organization within the firm.

Principal-agent theory introduces the incentive schemes but it misses the important factor that writing a good contract is costly. Transaction Cost Theories points out contracts are not comprehensive and are revised and renegotiated all the time and relationship-specific investment results in high ex ante costs, that is, a prior investment which creates value if the parties’ economic relationship extends over time, but does not if the parties split up. However, the theory could not provide the answer why there is less haggling and hold-up behavior in a merged firm.

All the theories above do not explain what changes when two firms merge. And the author therefore tried to address this question with the property rights approach. Provided with a simple model of two assets a1 and a2 and two managers operating them, M1 and M2 that illustrates the benefits and costs of integration, the author discussed on three “leading” ownership structures: Non-integration in which M1 owns a1 and M2 owns a2, Type 1 integration in which M1 owns a1 and a2, Type 2 integration in which M2 owns a1 and a2.

Considering the investments and payoffs, ex post division of surplus, proposition 1 is pointed out that under any ownership structure, there is underinvestment in relationship-specific investments. Based on the ex ante division of surplus, analysis of the optimal ownership structure, some key points in proposition 2 are raised. There is no point giving ownership rights to a party whose investment decision is not responsive to incentives. There is also no point giving ownership rights to a party whose investment is unimportant.

If assets a1 and a2 are independent, then non-integration is optimal and if a1 and a2 are strictly complementary, then some form of integration is optimal. If M1’s (resp. , M2’s) human capital is essential, then type 1 (resp. , type 2) integration is optimal. If both M1’s human capital and M2’s human capital are essential, then all ownership structures are equally good. More generally, in the absence of wealth constraints, firm boundaries are chosen to allocate power optimally among the parties to a transaction.

A party is more likely to own an asset if he or she has an important investment decision. The theory also predicts that complementarities make integration more likely and, conversely, that independent assets should be owned separately. The simple model above also helps us to understand changes in organizational structure over time that a number of commentators have argued that a trend toward de-integration has occurred in the 1980s and 1990s.

In my opinion, to merge or not depends on benefits and costs of integration. A firm may think about the de facto control of its resources including its supplier. If the costs increase under the incomplete contracting and the firm has nothing to do with its limited control over its supplier, it may consider the integration. And just like a baby in arms, once you get the control of other firms or assets that are complementary to your own business, you will absolutely invest more to make it grow stronger.