1. [Lecture 2] What is ownership, and why does it matter?

Ownership is a form of contract that specifies decision rights over an asset and assigns its returns. In a complete contract, the ownership structure would be specified in all possible contingencies by the contract itself, i.e. no residual rights would be left. However, when the contract is incomplete (i.e. has gaps, missing provisions, or ambiguities), ownership becomes the right to exercise residual control in situations where some aspects of the uses of nonhuman assets are not specified, and the right to receive any residual returns remaining after contractual obligations have been paid. Standard economic theory cannot answer the question of why ownership matters. In general equilibrium theory, trade takes place anonymously in competitive markets. In game theory, market power relates to agents having the ability to influence the price level but does not say anything about the ownership structure and why it matters. Neither do mechanism-design or the principal-agent theories where the costs of contracting are assumed to be null. Transaction-cost economics do underline the costs of contracting as the rationale for the transactions to take place within firms, instead of passing through the market; nevertheless they do not emphasize or explain why the ownership structure is important. We need to turn to property rights theory to understand why ownership matters. Ownership would not matter if the contracts were complete, i.e. would specify actions, payments, etc. in all possible contingencies, or if there was perfect trust and implicit understanding between parties engaged in the transaction (no risk that either party may behave opportunistically if something unforeseen happens). In reality, however, contracts are almost always incomplete to the extent that something unspecified in the contract may happen and induce either party to take advantage of the situation at the expense of the other one. When contracts are incomplete, the ex ante allocation of residual rights matters a lot because it will affect the ex post division of gains from trade. Ownership is a source of power when contracts are incomplete. (O. Hart 1995). Ownership is thus substituting for the degree of incompleteness. I shall argue that both the protection and the allocation of ownership matter since if the residual rights and returns end up in the wrong hands, the usage of the asset, investment incentives, and the contracting might become inefficient. When a single person has residual rights and residual control, it will be in her interest to maximize the total value of the entity owned because this will also maximize her own personal returns. However, if rights are insecure or temporal, the owner wont have enough incentives to preserve or enhance the value of the assets he owns anticipating that

he might lose the benefits of his efforts. For instance, bicycle riders may be unwilling to install lights if they are afraid that these could be stolen. Similarly, a flat renter will have less incentive to look after his accommodation and enhance it because his ownership rights are only temporal. Another instance of inefficient asset usage arises when ownership rights are unassigned. For example, common ownership of assets may lead to the tragedy of the commons. Shared resources may be abused because of the free-rider problem that occurs if the residual returns to the asset are widely shared so that no single individual has enough incentive to bear the cost of maintenance or enhancement of the asset. Fishing rights (over-fishing), and petroleum deposits (over-pumping) are good examples of this problem generated by unassigned ownership. By assigning the ownership to a group of people or a single individual, we may hence increase efficiency of the assets usage. In the case of fishing rights, the group could solve the problem by deciding on the total catch, who may fish in which area, when is fishing permitted It could be claimed that once ownership rights are tradable and secure and bargaining costs low, the Coase theorem should apply so that the initial assignment of ownership rights would not matter as long as they are clearly assigned to some party. People would trade property rights until the new ownership pattern is efficient. In such a situation untraded rights would simply indicate that the exchange was not worth the cost. However, this does not have to be the case; if the agreements made between participants in the bargaining process also affect the non-participants through negative externalities, trading of ownership rights may not lead to efficiency if the latter comes at the expense of the non-participating parties. Even if the markets are complete (no externalities), ownership rights are usually difficult to transfer. It this case the initial allocation of ownership rights will matter a lot and depend on the nature of the asset in question. If the asset is specific to a particular use (much less valuable in its next-best use), hold-up-problems may arise in case the ownership of this specific asset does not belong to the final user. Suppose the final user is not the owner of the asset. Then he could threaten not to use the asset so as to extract better terms from the owner of the asset. The latter anticipating this expropriation, will have less incentives to invest in improving the asset. Similarly, two co-specialised or complementary assets (i.e. having no or little value, except for their scrap values, outside this specific transaction) should be owned by the same person because a breakdown in the bargaining process, that could occur as a result of both parties holding-up and trying to exert better terms from the other party, would lead to large losses on both transaction sides.

One could argue that such hold-up problems would be innocuous if some valuemaximizing arrangement between both parties is still achieved, which is to be expected if the total benefits from this arrangement are higher than the costs. In this case ownership would not matter because it would only influence the repartition of the gains from trade but not the social value or efficiency of the arrangement. The problem is that ex ante anticipation of the negotiation stage and the fear that the other party could expropriate part of the surplus, will lead both parties to under-invest in the specific or co-specialized asset, thereby leading to a destruction of value due to specialisation. Note that these hold-up problems would not arise if both parties were trading general-purpose goods. In such case a breakdown of negotiations would simply lead either party to find another trading partner and competitive forces would drive the prices towards market equilibrium values. However, this does not mean that ownership does not matter when assets are not specific. In fact, it still matters a lot: efficient ownership should be separate in the case of independent assets. Suppose a firm acquires another firm producing a completely independent asset. After the transfer of residual rights, the latter firms managers will have no incentive anymore to invest in cost-saving and qualityenhancing technologies anticipating that a large part of the surplus from such investment would be expropriated by the acquiring firm.

2. [Lecture 2] [Tripos 2011] Consider a car company that is deciding whether to outsource the production of some its car parts to an external supplier. (a) Discuss the potential costs and benefits of pursuing such an outsourcing strategy. (b) Explain possible ways in which the car company can manage the relationship with its supplier. (c) What does the empirical evidence on vertical integration in the car industry suggest?

a_
Potential costs and benefits of such outsourcing depend on the degree of relationspecificity of the car parts in the firms assembly line. For instance, asset-specificity would arise if the car company uses as an input some specific parts that are not generalpurpose (common to other car makers). Site-specificity would occur if the factory producing parts and the assembly line are located nearby.

First, suppose that the parts are highly specific. Outsourcing implies that the firm loses the residual control rights over the production of the parts and the possession of residual income from any quality-enhancing or cost-saving investments the parts supplier might make in the future. If the contract between the car maker and the supplier is incomplete and short-term, it will have to be renegotiated when some unforeseen contingency arises. Suppose demand for cars increases, and the car maker wishes to increase production. It is at the renegotiation stage that all the potential costs of the outsourcing will become evident. Firstly, there might be some time-consuming and wasteful haggling over the renegotiation with no consensus over the terms of the new contract. Secondly, asymmetric information might lead to an inefficient contract. For instance, if the outsourced parts suppliers production costs have decreased without the car maker actually aware of this, the car maker could propose a price that is higher than the efficient one. Similarly, even if the renegotiation does succeed, to induce the supplier to produce extra parts, the car company might have to offer a price that is too high relative to what it would have enforced without the outsourcing, thereby forgoing part of the profits from increased car sales. Furthermore, such outsourcing would induce both the car company and the parts supplier to make more general-purpose investments in anticipation of the problems that could arise at the renegotiation stage. The car company would try to modify its assembly line such that any universal car parts could be used instead of the specific ones. Similarly, the parts supplier will also try to invest in producing general-purpose car parts. This of course means that both will become less vulnerable to hold-up problems arising from the other party threatening not to buy or supply the specific parts in order to extract a larger surplus. However, from a social point of view, efficiency benefits from specialisation would be sacrificed and large unnecessary costs may be borne if these general-purpose investments are in fact inefficient. These costs wont occur if the parts the car company uses are general-purpose from the beginning. In this situation, if it wanted to produce more cars and the current supplier were unwilling to fabricate these extra parts; the car company could always negotiate with another supplier. In this scenario, the outsourcing could potentially provide benefits to the car company. The outsourced supplier will have more incentives to invest in cost-saving and quality-enhancing technologies anticipating that most of the surplus from such investments will remain within the firm. One may think that this represents an opportunity cost to the car company because it wont be able to extract part of the

surplus from such investments. However, this is not right because without the outsourcing the investment would not have occurred at all (supplier anticipating surplus expropriation). Indirectly, the car company may still benefit if the parts become better and less expensive. In fact, due to competition in the parts market, some of the costsaving is likely to be passed on to the car manufacturers. Thus, traditional property rights theory suggests that, in the context of highly specific parts, outsourcing might yield more costs than benefits, whereas the reverse would probably occur in case of universal car parts. However, potential costs and benefits will also depend on the duration of the interaction, the availability of complex long-term contracts, as well as trust and reputation considerations between the external supplier and the car maker. The longer the interaction period, the more unforeseeable contingencies might arise making the outsourcing less attractive because of potential time-consuming and wasteful renegotiations or supplier switching costs. Nevertheless, the availability of suitable complex long-term contracts, enhanced by trust and reputation considerations, may diminish the fears of expropriation of relationship-specific investments on both transaction sides and make the outsourcing efficient.

b_
The car company could manage its relation with the parts supplier through either a long-term complex contract or a short-term arms length one: An arms-length contract is the relationship that involves the lowest level of implication. The transactions start at a specific date and the exchange consists of standard products or services in standard terms and conditions. During the length of the contract, the terms and conditions are rigid, i.e. cannot be renegotiated. When the contract expires, the relationship ends. The parties are then free to choose other trading partners or to re-contract again. Though an arms-length contract can also be specified for a long period of time, a long-term contract is different in nature. It gives more flexibility and possibilities for re-specification over time. It has a commitment aspect and involves a more complex relationship between the parties involved. Consumption smoothing and high negotiation costs would make a long-term contract preferable.

c_

Empirical evidence suggests that manufacturers fabricate some parts themselves while buying others from outsourced suppliers and that important international differences exist. For instance, General Motors the US largest car maker produces a higher fraction of its parts in house than its Japanese rival Toyota. The competitors ownership structures are distinct even though both employ rather specific parts in their assembly lines. Though GM has a more vertically integrated structure, the parts produced in house tend to be highly specific compared to those parts that GM outsources to external suppliers. GM obtains the latter from thousands of competing suppliers with whom GM signs arms-length, short term, fixed price contracts. There is usually no repeated interaction between GM and these external suppliers. GM selects them through competitive bidding. This seems consistent with the analysis of potential costs and benefits from traditional property rights theory discussed above. On the other hand, the Toyota example illustrates how trust and reputational issue as well as the availability of complex long-term contracts might reduce the potential costs of outsourcing and make it profitable. Most of Toyotas parts more or less specific to Toyotas assembly line - are outsourced, but the number of suppliers is limited to a hundred. With each supplier, Toyota develops very close, complex, and long-term relationships that involve sharing of information and costs, as well as advising. A system of rewards and penalisations provides the necessary incentives for the sustainment of such long-term contracts: when Toyota starts developing a new model, only those suppliers that performed best are selected. It seems that the Japanese model is more attractive because since the mid 1980s, GM started reducing the number of its suppliers and establishing a closer relationship with those remaining.

4. [Lecture 4] [Tripos 2011] Since employees can always be induced to work hard with sufficient provision of incentives, moral hazard is not a problem for firms.Discuss.
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