TheNatureoftheFirmVerticalIntegration,andContractsBRUCE H. KOBAYASHI

Professor of LawGeorge Mason University Law School

Coase on Industrial Organization:“[I]f and economist finds something – a

business practice of one sort or another –that he does not understand, he looks for a monopoly explanation.”

Ronald H. Coase, Industrial Organization: A Proposal for Research, reprinted in The Firm, The Market and the Law, 67 (1988).

Coase and Theory of the Firm (1937)

• Organizing exchange through an organization will occur in order to economize on the costs of market transactions

• The costs of discovering market prices• The costs of negotiating a contract for each exchange transaction

• Theory extended used to analyze the make/buy decision and to study vertical integration (see generally, Klein, Crawford & Alchian (1978); Williamson (1971); Hart and Moore (2008)

• Theory extended and used to analyze hybrid organizations, e.g., franchising (Rubin 1978)

Real Estate Agents Selling Houses (91%):Buyer side: 3% of sale priceSeller side: 3% of sale price

Sold w/o Real Estate Agent (9%)

Real Estate Agents Selling Houses (91%):Buyer side: 3% of sale priceSeller side: 3% of sale price

Open House – Costs $1,000.00• Will increase sale price by an expected $10,000.• ROI for investment: 900%.

Open House – Costs $1,000.00• Will increase sale price by an expected $10,000.• ROI for investment: 900%• Marginal increase in Real Estate Agent’s

compensation = .06*$10K= $600.

Open House – Costs $1,000.00• Will increase sale price by an expected $10,000.• ROI for investment: 900%• Marginal increase in Real Estate Agent’s

Compensation when selling own home =$10,000

Real Estate Agents and Agency Costs:

Forward Integration - Retailing

Factors Determining Franchise/Own Decision:

• Importance of Downstream/Retail versus Upstream/Manufacturer Effort and Incentives

• Asset Specificity and Opportunism• Monopoly Power/Foreclosure• Ability to Enforce Contracts and Contract Law• Laws Restricting Vertical Integration (including but not limited to

Antitrust Law)

Effect of Retail Divorcement Laws

TimeT=0 (No divorcement) T=1 (divorcement in state S=1)

PS=1,T=0

First Difference S=1

PS=1,T=1

TimeT=0 (No divorcement) T=1 (divorcement in state S=1)

PS=1,T=0

PS=0,T=1

First Difference S=1

PS=1,T=1

PS=0,T=0

Difference-in-Difference = FD1 – FD0 < 0

First Difference S=0

TimeT=0 (No divorcement) T=1 (divorcement in state S=1)

PS=1,T=0

PS=0,T=1

First Difference S=1

PS=1,T=1

PS=0,T=0

Difference-in-Difference = FD1 – FD0 > 0

First Difference S=0

Asset Specificity, Hold-Up and Opportunism• Franchisee opportunism and free-riding on brand• Franchisor opportunism – termination at-will or non-

renewal• Threat of termination and loss of quasi-rents an effective

mechanism to bond franchisee performance, reduce agency costs, and prevent franchisee opportunism (Corenswet v. Amana case in readings)

• Can also allow franchisor to hold-up franchisee (expropriate up-front franchise fee, relationship specific assets

Payoutswithperformance

Payoutswithcheating

time

timet=0 T=1

ChoosePerformanceifπP(1+(1/r))>πC(1+(1/r)(1-1/(1+r)(T-1)

Payoutswithperformance

Payoutswithcheating

time

timet=0 T=5

ChoosePerformanceifπP(1+(1/r))>πC(1+(1/r)(1-1/(1+r)(T-1)

0"

50"

100"

150"

200"

250"

300"

1" 2" 3" 4" 5" 6" 7" 8" 9" 10" 11" 12" 13" 14" 15" 16" 17" 18" 19" 20"

Performance"Payouts" Chea;ng"Payouts"

ChoosePerformanceifπP(1+(1/r))>πC(1+(1/r)(1-1/(1+r)(T-1)

3πP =πC

r=.1

State Regulation of Franchise Contract

•  Coase&(1937):&the&“make&or&buy”&decision&depends&upon&the&rela>ve&costs&of&making&versus&using&market!&&

•  The&costs&of&contrac>ng&&–  Ink&Costs&&– Opportunism&&

•  If&reputa>onal&capital&reduces&the&cost&of&contrac>ng&(using&the&market),&one&implica>on&is&that&we&should&see&less&ver>cal&integra>on&in&markets&where&at&least&one&party&has&a&significant&reputa>on&to&put&on&the&line&&

•  A"firm"makes"two"make"or"buy"decisions:"– One"for"drycleaning""– Another"for"laundry"services""

•  Out;sourcing"means"that"the"firm"must"rely"on"the"reputa=on"of"the"supplier"for"performance""

•  What"does"Coase"have"to"say"about"the"incidence"of"ver=cal"integra=on"among"Korean"drycleaners"in"Koreatown"in"Los"Angeles?"""

•  Gil"and"Hartmann"(2009)"

• Social Networks:• Processors in LA Koreatown predominately are

Korean owned businesses.• For Korean run retail cleaning stores in

Koreatown:• Enhanced communication, reputation or trust• Decreased Cost of Market Transactions• Decreased use of vertical integration

• Not true for non-Korean owned retail stores or Korean owned retail stores outside of Koreatown

Data Description •  Data from laundry service stores.

–  173 stores surveyed. –  138 stores answered. –  4 areas in LA:

•  Korea Town (30+18) •  China Town/Downtown (30). •  Century City (30) •  Santa Monica (30).

•  Tract level demographic information.

Source:GilandHartmann,AiringYourDirtyLaundry:VerticalIntegration,ReputationalCapital,andSocialNetworks,27J.L.Econ.&Org.219(2011)

Successive Monopolies

D1

MR

MC

Q

$

P*=6

c=2

Q*=4

MonopolyProfit=16

Successive Monopolies

D1

MR=DM

MC

Q

$

P*=6

c=2

Q*=4

RetailProfits=4ManufacturerProfits=8PR=8

QR=2

MRM

Successive Monopolies

D1

MR

MC

Q

$

PR =P*=6

PM=2

Q*=4

Solutions:• VerticalIntegration• FranchiseFee=MonopolyProfit=16,• MaximumRPM

Performing Rights Organizations as Coasian37’ Organizations

• BMI, ASCAP, SESAC• Organizations are “a market response to copyright problems caused

by high transactions costs. Number of users of copyrighted music makes individual negotiations with individual copyright holders to acquire performance rights infeasible." (Landes and Posner (1989))

Performing Rights Organizations as Coasian37’ Organizations

• BMI, ASCAP, SESAC• Organizations are “a market response to copyright problems caused

by high transactions costs. Number of users of copyrighted music makes individual negotiations with individual copyright holders to acquire performance rights infeasible." (Landes and Posner (1989))

• PROs eliminate the costs of individual market transactions with blanket licenses to entire repertoire.

• Are responsible for distributing license fees net of costs to songwriters or publisher that holds the copyright to the musical work

Performance Rights Organizations (not involving digital audio transmission) in U.S.

• License and collect performance royalties for publishers and songwriters

• Do not collect songwriters/publishers mechanical royalties (some are collected by organizations such as the Harry Fox Agency)

• Do not collect digital performance royalties (collected in the U.S. by SoundExchange)

• In other countries a single copyright collectives collects multiple performance royalties (for composition and sound recording) or performance and mechanical royalties.

Antitrust and Consent Decrees• Antitrust Decrees entered into in 1941 with BMI and ASCAP (but not

SESAC) oversee the rates charged:• Require that ASCAP and BMI to license all similarly situated users of music

under the same rates and standards• Rate Court oversight (currently SDNY) to determine reasonable rates when

voluntarily negotiations between PRO and music licensee do not result in an agreement

• Last modified in 2001 (ASCAP) and 1994 (BMI)• Congressional Hearings and DOJ Consent Decree Review

• Allow ASCAP and BMI to expand beyond current business model and license rights other than rights to public performance

• Replace rate courts with mandatory arbitration• Allow ASCAP and BMI to allow rights holders to withdraw rights for some types

of users

Digital Performance Right in Sound Recordings Act of 1995 (DPRA)

• 17 U.S.C. §§106(6), 114-5• Owners of copyright in sound recordings have an exclusive right to

public performance by means of a digital audio transmission• Non subscription broadcast transmissions (e.g., terrestrial radio stations)

exempt• Non-interactive internet transmissions required to pay a statutory license

established by the Copyright Royalty Board (Pandora, Web Radio, Satellite Radio), administered by Sound Exchange

• Interactive Internet transmission services must negotiate a license agreement with the copyright holder (YouTube)

• Payments are in addition to those paid for public performance or the musical composition

MUSICALCOMPOSITIONRIGHTS

SOUNDRECORDINGRIGHTS

Withdrawal of Digital Rights from BMI/ASCAP

• EMI announces intent to withdrawal from ASCAP in 2010• Compendium modification by ASCAP to allow partial withdrawals of

performance rights from ASCAP• EMI, Sony and UMPG announce intention to withdraw of new media

rights from ASCAP• Direct negotiations with large new media entites (including non-

interactive services such as Pandora and iTunes radio)• Rate Court holds that partial withdrawals are not allowed under modified

consent decrees• Pandora v. ASCAP• Pandora v. BMI

MUSICALCOMPOSITIONRIGHTS:

SOUNDRECORDINGRIGHTS

PROFULLREPERTOIRE

PUBLISHERDIRECTPROPARTIALREPERTOIRE

Coase 1937 and the Rate Court’s Hobson’s Choice

• Technological change and changes to the copyright laws has changed the nature of transactions costs that determined the nature of the PROs

• One would expect PROs to adapt to these changes, or face obsolescence when that copyright holders choose to use alternative mechanisms to appropriate the royalties from public performances.

• Indeed, this is what we have observed, with integrated music publisher (owning copyrights to performances and sound recordings) attempting to withdraw their digital rights from both ASCAP and BMI.

• The rate court’s creation of a Hobson’s choice in an attempt to continue the application of the antitrust consent decrees will:

• Speed the demise of traditional PROs• Raise transactions costs for the traditional users of works that remain in ASCAP and

BMI• Prevent use of potentially more efficient alternative to price determination through

consent decree

MUSICALCOMPOSITIONRIGHTS©:

SOUNDRECORDINGRIGHTS℗:

PROFULLREPERTOIRE

PUBLISHERDIRECTPROPARTIALREPERTOIRE