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Organizational Industrial Organization

Periodic Report Summary 2 - OIO (Organizational Industrial Organization)

Questions related to firm boundaries (the extend of authority linked to ownership) and delegation (an internal organisation question) have until now received separate attention, both theoretically and empirically. In our theoretical work, we provide a single framework to analyze both questions and show that while non-integration of suppliers (decentralization of decision making outside firm boundaries) and delegation (decentralization of decision making within firm boundaries) are observationally similar in terms of “who decides”, they are qualitatively, and quantitatively, quite different. They are qualitatively different because delegation is a decision made by the producer after the supplier is integrated and will happen only if the supplier has a comparative advantage over the producer for making decisions, while under non-integration the supplier always makes the decision. In other words, integration creates a real option and we show that the value of the option is always increasing in the productivity of the producer and, under some conditions, in the riskiness of the supplier’s productivity. Because the benefit of integration is also increasing in the productivity of the producer, when a producer integrates more suppliers — when there is less non-integration— he will delegate more often; hence non-integration and delegation are quantitatively different, in fact they covary negatively.
This theoretical work is supported by an econometric analysis based on an original dataset combining three types of information about firms’ organizations: the degree to which intermediate suppliers are integrated within the firm boundaries and are therefore subject to the common authority of the downstream producer, the degree to which this producer, delegates certain decisions to his integrated suppliers and, finally, data on the quality of management (use of incentives schemes, monitoring, improvements in logistics). This unique dataset has allowed us to confirm the negative covariation between delegation and non-integration, as well as the positive relationship between riskiness of suppliers’ productivity and integration.
These results highlight the importance to distinguish between different modes of decentralization of decision making in an economy. Both decentralization in the market, outside firm boundaries, and decentralisation within firm boundaries affect the productivity of firms and industries but, as we have shown, in opposite ways.
Beyond the positive analysis of integration decisions, the theory has some normative implications that are important for regulation. We analyze whether policy makers should use their power to control the degree of integration in an industry, e.g. by preventing mergers or by forcing divestitures of integrated entities. When firms have market power, the received wisdom is that there is a direct relationship between more market power and high prices. Equipped with such a wisdom, a regulator who observes a joint increase in prices and in the degree of integration (mergers, increased concentration) may conclude that the culprit for higher prices is integration, and decide that forcing firms to divest some assets will lead to a reduction in prices. We argue that when synergies brought by integration are higher when the monetary returns are higher (which is consistent with many modern theories of the firm), the level of demand has a causal effect on the level of price and on the concentration in the industry, but that there is reverse causality between integration and prices: it is because prices are high (because of high demand) that firms integrate. It follows that when the policy maker forces firms to divest assets (to disintegrate or divorce), firms are less efficient and prices may be higher than without regulatory intervention. We show how this logic is consistent with previous empirical findings on the effects of divorcement policies in the beer industry, both in the UK and in the US.