Integration, Long-Term Contracts and Hold-Up Theories: Fisher Body and General Motors - Literature review Example

Literature Review: HOLDING UP GENERAL MOTORS? ISSUES IN THE FISHER BODY CASE STUDY Introduction From 1919 to 1926, General Motors (GM) and FisherBody (FB) had a relationship underscored by an “exclusive supply contract” in which GM was required to purchase bodies from FB (Roider, p. 2006, 182). Thereafter GM vertically integrated FB and this vertical integration emerged as a significant example in the literature of the role of vertical integration and/or hold-up risks associated with long-term contracts in transaction cost theory (Roider, 2006). This literature review conducts a critical analysis of the literature in which the vertical integration of FB by GM is used as an example of either the role of hold-up risks in long-term contracts or the role of vertical integration in transaction costs analysis. Thus the literature review is divided into two parts. The first part of the literature review presents an analysis of transaction costs, specifically the role of long-term contracts/the hold-up problem, and vertical integration in the decisions of firms. The second part of the literature review presents a critical analysis of the role of vertical integration, long-term contracts and hold-up theories in transaction costs analysis in the context of the FB-GM case. 2. Transaction Costs: Long-Term Contracts, Vertical Integration and Hold-Up Theories The transaction cost theory was introduced by Coase (1937) who argued that in considering the acquisition of products and services, firms must consider much more than the mere price of those products and goods. In fact, other costs are factored in: information, search, bargaining/negotiations, trade secrets and monitoring/enforcement costs (Coase, 1937). The theory of transaction costs can therefore be used to understand organization decisions such as long-term contracts and vertical integration. The theory of transaction costs can also be used to explain and understand the role of hold-ups in the decision to opt out of a long-term contract and into vertical integration. Transaction costs theory can arguably explain the primary motivating factors for vertical integration (Levy, 1985). Using transaction cost theory it can be argued that decisions for vertical integration arise out of a need for and a corresponding lack of “supply reliability” and the desire to obtain “risk reduction” and to ensure greater certainty relative to future “events” (Levy, 1985, p. 443). In other words, applying transaction costs theory, a firm’s decision to engage in vertical integration may follow from a need to respond to competitive and market threats and are therefore not always purely profit-driven decisions. Klein (1980) also argues that since contracts are imperfect and cannot guarantee economic gains for all parties, long-term contracts often engage transaction costs analyses. Contracts do not always anticipate each and every contingency and as a result unanticipated events will expose the weaknesses of contractual arrangements and the vulnerability of one party to exploitation by the other contracting party. Quite often all of the rights and obligations of parties are not always accounted for in the context of a contract or some of the rights and obligations may be unclear or open to interpretation. One party may exploit these shortcomings in contracts in what is described as “the hold-up problem” (Klein, 1980, p. 356). It can also be argued that given the risks associated with the hold-up problem, it is conceivable that vertical integration is a viable option for firms (Klein, Crawford, & Alchian, 1978). Therefore, just as transaction costs directs the decision to opt in or out of vertical integration, transaction costs directs the decision to opt in or out of contract or to actually breach or act on anticipated breach of a contract. Transaction costs may also explain why a firm opts out of long-term contract and instead choses vertical integration. Case studies on the FB-GM vertical integration have been used to make this link since the parties were first committed to a long-term contract and subsequently opted for vertical integration. 3. Vertical Integration, The Hold-up Problem in the Case of Fisher Body and General Motors In Klein’s (2000) analysis of vertical integration of FB by GM, the imperfections of the initial contract was at the centre of the analysis. According to Klein (2000), imperfections arose as a result of the exigencies of imprecise obligations. During the contract stage, GM increased its demand for supplies from FB and the increase in demand was unanticipated. Fisher responded by “failing to make” the requisite “investments” in a “plain located near GM production facilities” (Klein, 2000, p. 105). This obviously became a hold-up problem since GM was bound by contract to purchase its automobile bodies from FB and was therefore not at liberty to purchase automobiles from elsewhere. According to Klein (2000), the vertical integration provided a number of solutions that would avoid uncertainties in the future and the imperfections implicit in a contract. However, Roider (2006) argues, vertical integration was not the only option available to GM and FB. The parties could have resolved the hold-up problem by avoiding the existing contract and renegotiating and securing a new contract altogether (Roider, 2006). However, if the transaction costs of the existing contract revealed the imperfections of contractual arrangements, namely that there are unanticipated market conditions and party behaviour that could compromise the gains of either or both parties, it is unlikely that a new contract would have solved the hold-up problem. In fact, in all likelihood, a new contract would only create a new set of imperfections and thus a new hold-up problem would arise again in the future. The vertical integration served to centralize and secure automobile demand and supply with far more predictability and certainty than the contractual arrangement provided and could provide. Coase (2006) challenged the facts relied on by Klien (2000) in his transaction costs analysis of the vertical integration by GM of FB. According to Coase (2006), it is inconceivable that GM would have been taking action under the contract that would have been calculated to take advantage of FB since GM owned 60% of FB. In other words, FB and GM were essentially one and the same for the most part. Therefore the hold-up problem was not the issue. According to Coase (2006) the main issue existed outside of the terms and conditions of the contract and not as Klein (2000) suggested. GM wanted FB to move its production plant closer to GM in Flint, Michigan and FB wanted to expand its Detroit plant as the expansion was more profitable to FB than the move to Flint (Coase, 2006). Coase (2006) therefore denies that there was a hold-up problem under the contract between FB and GM. The parties were engaged in what was described as a “normal business dispute” which eventually became a part of the negotiations for GM’s acquisition of the remaining 40% of FB (Coase, 2006, p. 271). Coase (2006) argues that the on-going relationship between FB and GM was such that the vertical integration would have occurred eventually although the dispute accelerated the integration. Coase (2006) agrees that the hold-up problem is an important factor in transaction cost analysis. However, he disagrees that the facts of the case support the contention that the vertical integration of FB by GM stands as a good example of the hold-up problem in transaction costs analysis (Coase, 2006). Regardless, Klein (2007) in referring to Coase’s (2006) argument that the FB and GM vertical integration is not a good example of the hold-up problem, stated that he has since had an opportunity to review the actual contract. According to Klein (2007) the contract between FB and GM was renegotiated in 1922 and the newly added terms were far more favourable to FB than they were to GM and thus put FB in a position to create a hold-up problem with respect to the cost of production. This was particularly so since the “cost-plus” terms in favour of FB remained the same while GM was still required to pay half the cost of production to ensure “asset specificity” (Klein, 2007, p. 1). Klein (2007) argues further that asset specificity is only one of many transaction costs that influence replacing a long-term contract with vertical integration. The FB-GM case demonstrated: That inherently imperfect contracts can in some circumstances be used to effectuate a holdup – increase with the magnitude of specific assets. This is because longer-term, more restrictive contract terms are more likely to be required as specific assets increase. Consequently, as specific assets increase, vertical integration becomes a more likely alternative organizational solution to potential holdup problems (Klein, 2007, p. 2). It would therefore appear that in determining whether or not the vertical integration by GM of FB is a classic case of the hold-up problem in transaction costs analysis, much depends on how the facts are interpreted. However, the fact that GM already owned 60% of FB undermines the argument that it represents a classic example of the hold-up problem in transaction cost analysis since the two companies would primarily share the same transaction costs and were practically a single entity already. A party creating or acting opportunistically in such circumstances is inconceivable since it would be harmful to both parties. It would appear that the final act of integration as Coase (2006) suggested, would eventually occur regardless. Casadesus-Masanell and Spulber (2000) also dispute the contention that the FB-GM vertical integration is a classic example of the hold-up problem in transaction cost theory of the firm. These assumptions are based on “errors of historical fact and interpretation” (Casadesus-Masanell & Spulber, 2000, p.67). Casadesus-Masanell and Spulber (2000) like Coase (2006) point to the fact that GM owned 60% of FB. In addition, prior to the vertical integration of the two companies, they worked well together and the relationship was built on “trust” as opposed to “opportunism” (Casadesus-Masanell & Spulber, 2000, p. 67). The merger was calculated to improve the “coordination of production and inventories” so that GM could be assured that it had the requisite supply of automobile bodies and FB’s talent (Casadesus-Masanell & Spulber, 2000, p. 67). Pujol (2011) argues that it is difficult to know whether or not Klein’s (2000; 2007) theory that the vertical integration by GM of FB was a result of a contract hold-up problem or Coase’s (2007) argument that the parties worked in harmony are the correct interpretation of the fact. The main problem is that both Klein and Coase are reconstructing a scenario that neither one was a direct witness to (Pujol, 2011). It would therefore appear that the best methodology for determining whether or not the vertical integration was a result of conflict facilitated by the hold-up problem or a simple advancement of a pre-existing congruous relationship is to conduct a further search of the historical facts. As it currently stands, the known facts have proven to be ambiguous and capable of interpretation to corroborate the arguments of both Klein and Coase. To Klein’s credit, the theory of transaction costs informs that where there are opportunities for achieving an advantage in the market, firms will exploit that opportunity if the costs of doing so is not disproportionate to the gains. Moreover, where there are risks of losing an advantage and opportunities for gaining leverage against a party presenting that risks, the party will take advantage of the opportunity for gaining leverage. Thus it can be argued that the contract hold-up was an opportunity for FB to engage in opportunistic behaviour by creating or acting on a contract hold-up as a means of either gaining an advantage in the market or gaining leverage over GM in a dispute. Likewise, to Coase’s credit, GM and FB arguably had an on-going relationship in which GM held 60% of the shares in FB and thus it is conceivable that they were virtually one unit. As a result it would not be to either firm’s advantage to engage in opportunistic behaviour and certainly a contract between them would eventually be replaced by a complete merger. It is therefore impossible to state with any degree of certainty whether or not a hold-up problem contributed partly or wholly to the vertical integration of FB and GM. Works Cited Casadesus-Masanell, R. and Spulber, D. F. 2000. “The Fable of Fisher Body.” Journal of Law and Economics, 43(1): 67-104. Coase, R. H. November 1937. “The Nature of the Firm”. Economica, 4(16): 386-405. Coase, R., 2006. “The Conduct of Economics: The Example of Fisher Body and General Motors.” Journal of Economics & Management Strategy, 15(2), pp. 255-278. Klein, B.; Crawford, R. G. and Alchian, A.A. October 1978. “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process.” Journal of Law and Economics, 21(2): 297-326. Klein, B. May 1980. “Transaction Cost Determinants of ‘Unfair’ Contractual Arrangement.” The American Economic Review, 70(2): 356-362. Klein, B. 2000. “Fisher-General Motors and the Nature of the Firm.” Journal of Law and Economics, 43(1): 105-141. Klein, B., 2007. “The Economic Lessons of Fisher Body-General Motors.” International Journal of the Economics of Business, 14(1), pp. 1-36. Levy, D. T. August 1985. “The Transaction Cost Approach to Vertical Integration: An Empirical Examination.” The Review of Economics and Statistics, 67(3): 438-445. Guerra-Pujol, F. E. 2011. “Holdups and History: The General Motors-Fisher Body Merger Revisited.” U.P.R. Business Law Journal, 21-34. Roider, A. 2006. “Fisher Body Revisited: Supply Contracts and Vertical Integration.” European Journal of Law and Economics, 22: 181-197. Critical Bibliography Freeland, R. F. April 2000. “Creating Holdup Through Vertical Integration: Fisher Body Revisited.” Journal of Law and Economics, 43(1): 33-66.Using primary documents evidencing the historical facts, Freeland argues that GM invested in FB so that it could benefit from Fisher’s talent. Secondly, hold-up did not cause the vertical integration. Rather it was GM’s need to ensure that FB did not eventually leave. Moreover, after the integration, FB’s behaviour as a part of GM demonstrates that vertical integration did not prevent opportunistic behaviour but rather caused it. Klein, B. Spring 1988. “Vertical Integration as Organizational Ownership: The Fisher Body-General Motors Relationship Revisited.” Journal of Law, Economics & Organization, 4(1): 199-213. Klein explains how his earlier article co-authored with Alchian and Crawford was intended to be an extension of Coase’s transaction costs theory. In that article it had been argued that when firm-specific assets are increase, transaction costs likewise increase and vertical integration becomes more likely. This was demonstrated by the Fisher Body-General Motors case. However, since Coase rejected this argument, Klein defends, restates and further clarifies his theory. Nicita. A. and Sepe, S. M. December 2012. “Incomplete Contracts and Competition: Another Look at Fisher Body/General Motors?” European Journal of Law and Economics, 34(3): 495-514.Nicita and Sepe propose an alternative to the contract hold-up explanation for the Fisher Body-General Motors vertical integration. In this alternative explanation (hold-up competition) the presence of outsiders factored into the transaction costs analyses of both parties. Williamson, O. E. and Winter, S. G. 1993. The Nature of the Firm: Origins, Evolution, and Development. Oxford, UK: Oxford University Press. The Fisher Body- General Motors case demonstrated that long-term contracts together with the reputations of the parties can contain hold-ups. However, long-term contracts have the potential to create hold-ups nonetheless as Fisher made demands that the contract itself was designed to prevent. Wood, J.C. and Wood, M.C. Alfred P. Sloan, Jr.: Critical Evaluations in Business and Management. New York, NY: Routledge. General Motors and Fisher Body both realized that their contractual terms were not perfect and not complete and eventually there would be holdup if conditions in the market changed to move either or the parties “outside the self-enforcing range” (p. 305). Read More