Econ 106I (Galles) – Lecture 9 (March 9th, 2005)

 

Klein, Crawford, Alchian

 

Small-numbers ex-post opportunism

            Competition to enter into a relationship

 

Can this opportunism affect the production function?  Of course.

 

Inventories reduce this opportunism, but not costlessly so.

 

Want to find lowest cost way to reduce this.

 

3 ways to deal with this

            Explicit contracts – enforced by courts (least common)

            Implicit contracts – “I will make it in your best interest to continue to treat me well.”

            Vertical integration – Merge ownership to eliminate incentives to rip each other off

                        There are costs to this as well – management costs.

 

(p. 304)  Implicit contracting mechanism

 

McDonald’s has a huge reputation – Appropriable quasi-rents are potentially high for franchisees

 

**Diagram**

 

If growth rate slows, the premium stream falls and cheating begins.  (Similarly for decline)

 

If it is clear that the relationship will terminate in the future, there will be cheating today.

 

As the appropriable rent increases, the premium stream must increase as well, so at some point, it is more efficient to have vertical integration.

 

When things start to fall apart, they fall apart very rapidly.  “It is time to cheat now while I still can.”

 

Bonding mechanisms can be useful.

            IHOPs must be really weirdly shaped – can’t be used well for anything else

            Tasty Freeze example in the footnote

            Hardware/software example

 

Corporate America started misspelling stuff to get around copyrights.

 

(Footnote 16, p.304)  There could be many ways to pay the premiuim stream.  Advantage for conglomerates – can use reputation for many different products.

            Exclusive territories, initial specific investments, termination clauses.

 

(Footnote 17)  Last period problem – preserving on-going relationships alleviates this.  Reputation effects.  On-going third party introduction.

 

Unions can act as these on-going third parties.

 

(Footnote 18)  On-going social relationships can internalize this as well.

 

Applications (p. 308):

 

Car doors – need stamping machine (unique design on stamp) – possible appropriable quasi-rent

            Fisher Body/GM case.  How did they try to solve it?  They started with explicit contracts.  Fisher body couldn’t take advantage of GM and conversely so.  But then, conditions changed and PV premium increased.  GM wanted Fisher Body to move closer.  They refused and they they eventually vertically integrated.

 

Petroleum industry – pipelines are not easy to move.  High appropriable quasi-rents possible.  Vertical integration

            Oil tankers, on the other hand, are not specialized to a particular user.  No vertical integration here.

            Some refineries located near coast to have substitutes available.

 

Great Lakes Carbon – Built plants right next to refineries to use the by-products.  Needed long-term contracts to protect themselves.

            Courts accused them of anti-trust.  They did not recognize the need of long-term contracts

 

Rockefeller (p. 312) – Oil by railroad tank car.  Not specialized to users.

            Credible threat to build pipeline parallel to a railroad by Rockefeller – Expropriated these quasi-rents.

            Standard oil got rebates from the railroads

 

Specific human capital (p. 313) – Attituted of an owner of a peach crop to a union – the entire value of the peach crop can be expropriated,  so owner does not like unions, clearly.

            If forced to have a union, want to have a union that has a reputation for not taking advantage of firms.

                        But unions are unowned.  How do they take reputation effects into account?  Restricted entry to children of current employees (nepotism)

                                    Government outlawed this – then there were higher wage demands

 

(p. 316)  Wage rigidity – If you set a wage, you have incentives to try to get more.  But if you agreed in advance through an ex-ante contract.  Protecting yourself against this micro rip-off exposes you to macro rip-offs, though.

 

Prime plus contracts – protects you against macro problems

            Also acts as insurance to prevent ripping off.

 

Most favored nation contracts – If I lower my price soon after I sell to you, I will give you a rebate.

            China wanted most favored nation contracts to protect themselves against American rip-offs.

 

Growth of demand and trust – you become very trustworthy as present value premium increases.  Then contracts become very flexible.

 

Flexibility of Japanese wage payments since demand for Japanese products grew over time.  (Large PV premium)  As the demand growth decreased, they became more like American firms.

 

Railroads specialized to the engines – the railroads would own the engines.  As engines became more generalized, leasing arrangements became more widespread.

 

(p. 320)  Swift – inventor of refrigerated rail cars – originally owned their own rail cars.  As this process became more widespread, they stopped owning them.

 

Land-rail contracts – explicit contracts work pretty well

            Easy to monitor and enforce

 

Employees can own and manage a firm, but they would have to own the capital to be successful.  There is a reason why capitalists own the capital.  Credibility with respect to promises of wage payments.

 

Progress payments eliminate appropriable rent problem by decreasing differential between benefits and costs by adjusting the timing of the deals.

 

Read Telser, Klein-Saft