Yale Journal on Regulation Vol.19:171.2002 above cost. This price increase will lead customers to substitute alternative inputs whenever possible, a reaction that reduces the monopolists market power and decreases the profits it earns. The input can eliminate the reduction in profits resulting from input substitution by vertically integrating into fabrication Chicago school scholars conceded that under these circumstances . a monopolist could use vertical integration to earn positive profits, but tended to downplay the significance of the insight. Subsequent economists have largely agreed, in part because the welfare implications of input substitution are actually quite ambiguous. Although input substitution can reduce monopoly profits, it also reduces total welfare by inducing customers to deviate from the most efficient input mix Determining which of the two countervailing effects will dominate can be quite difficult. In any event, any reduction in welfare is likely to be relatively small. As a result, the consensus position is that input substitution does not pose a problem significant enough to be worth redressing. And even in markets where market power exists, it 73 The monopolist could accomplish much the same effect through vertical contractual restraints requiring that customers agree not to substitute inputs 74 See BORK, supra note 70, at 229-31(arguing that input substitution rarely occurrs and a result was an insufficient basis for regarding vertical mergers as anything but per se legal); POSNER, supra note 69, at 201( and probably an unanswerable one in the as yet at least, for prohibiting these vertical mergers either )(footnote omitted), McGee Bassett, supra note 72, at 32, 38(accepting the insight, but arguing that it should be addressed through eorge A. Hay, An Economic Analysis of vertice 1 IND. ORG. REV. 18 (1973); Richard Schmalensee, A Note on the Theory of vertical Integration, 81 J. POL. ECON. 442, 448 (1973); Frederick R. Warren-Boulton, Vertical Control with Variable ProportionS, 82 J. POL. ECON 783,79496,798,799(1974) 76 SCHERER Ross, supra note 72, at 523-24 ("The mathematical conditions underlying this result are complex. ) Specifically, the welfare tradeoff described above turned largely on the elasticity of substitution and the elasticity of demand for the final Economists that have assume that the final product market is perfectly competitive have disagreed over the range of elasticities that rice increase. Compare Hay, supra note 75, at 194: Warren-Boulton, supra note 75, at 784, 787, 799; and Schmalensee, supra note 75, at 447, with Parthasaradhi Mallela& Babu Nahata, Theory of vertical Control with variable Proportions, 88 J. POL. ECON. 1007, 1014-15(1980), and Fred M Westfield, Vertical Integration: Does Product Price Rise or Fall?, 71 AM. ECON. REv. 334, 335-346 (1981). Scholars that have modeled the final product market as oligopolistic have reached similar re Michael Waterson, Vertical Integration, Variable Proportions and Oligopoly, 92 ECON. J. 129, 139(1982)(concluding that, if the final product market is oligopolistic rather ompetitive, the impact on welfare depends on the elasticity of substitution), with Abiru, supra note 72, at 324(employing similar assumptions to conclude that price will fall and welfare will increase regardless of elasticity of substitution) than a couple percent), Reiffen Vita, supra note (drawing the same conclusion) See Perry, supra note 72, at 192([ ar that variable proportions models of vertical integration seldom have been regarded as providing a sound basis for guiding vertical merger enforcement policy
Yale Journal on Regulation Vol. 19:171, 2002 190 above cost. This price increase will lead customers to substitute alternative inputs whenever possible, a reaction that reduces the monopolist’s market power and decreases the profits it earns. The input can eliminate the reduction in profits resulting from input substitution by vertically integrating into fabrication.73 Chicago School scholars conceded that, under these circumstances, a monopolist could use vertical integration to earn positive profits, but tended to downplay the significance of the insight.74 Subsequent economists have largely agreed, in part because the welfare implications of input substitution are actually quite ambiguous.75 Although input substitution can reduce monopoly profits, it also reduces total welfare by inducing customers to deviate from the most efficient input mix. Determining which of the two countervailing effects will dominate can be quite difficult.76 In any event, any reduction in welfare is likely to be relatively small.77 As a result, the consensus position is that input substitution does not pose a problem significant enough to be worth redressing.78 And even in markets where market power exists, it is 73 The monopolist could accomplish much the same effect through vertical contractual restraints requiring that customers agree not to substitute inputs. 74 See BORK, supra note 70, at 229-31 (arguing that input substitution rarely occurrs and as a result was an insufficient basis for regarding vertical mergers as anything but per se legal); POSNER, supra note 69, at 201 (arguing that “[w]hich effect dominates is an empirical question in each case, and probably an unanswerable one in the present state of economic science. There is accordingly no basis, as yet at least, for prohibiting these vertical mergers either”) (footnote omitted); McGee & Bassett, supra note 72, at 32, 38 (accepting the insight, but arguing that it should be addressed through horizontal remedies). 75 See George A. Hay, An Economic Analysis of Vertical Integration, 1 IND. ORG. REV. 188 (1973); Richard Schmalensee, A Note on the Theory of Vertical Integration, 81 J. POL. ECON. 442, 448 (1973); Frederick R. Warren-Boulton, Vertical Control with Variable Proportions, 82 J. POL. ECON. 783, 794-96, 798, 799 (1974). 76 SCHERER & ROSS, supra note 72, at 523-24 (“The mathematical conditions underlying this result are complex.”). Specifically, the welfare tradeoff described above turned largely on the elasticity of substitution and the elasticity of demand for the final good. Economists that have assumed that the final product market is perfectly competitive have disagreed over the range of elasticities that lead to a price increase. Compare Hay, supra note 75, at 194; Warren-Boulton, supra note 75, at 784, 787, 799; and Schmalensee, supra note 75, at 447, with Parthasaradhi Mallela & Babu Nahata, Theory of Vertical Control with Variable Proportions, 88 J. POL. ECON. 1007, 1014-15 (1980); and Fred M. Westfield, Vertical Integration: Does Product Price Rise or Fall?, 71 AM. ECON. REV. 334, 335-346 (1981). Scholars that have modeled the final product market as oligopolistic have reached similar disagreement. Compare Michael Waterson, Vertical Integration, Variable Proportions and Oligopoly, 92 ECON. J. 129, 139 (1982) (concluding that, if the final product market is oligopolistic rather than competitive, the impact on welfare depends on the elasticity of substitution), with Abiru, supra note 72, at 324 (employing similar assumptions to conclude that price will fall and welfare will increase regardless of elasticity of substitution). 77 Perry, supra note 72, at 192 (noting that the percentage welfare loss appears to be less than a couple percent); Reiffen & Vita, supra note 72, at 923 (drawing the same conclusion). 78 See Perry, supra note 72, at 192 (“[I]t is not clear that variable proportions raises a major policy issue on vertical integration.”); Reiffen & Vita, supra note 72, at 923 (“The variable proportions models of vertical integration seldom have been regarded as providing a sound basis for guiding vertical merger enforcement policy.”)
Vertical Integration and Media Regulation in the New Economy arguable that horizontal remedies will prove more effective in curbing it than any prohibition of vertical integration or vertical restraints The second exception is more significant for the purposes of this Article. It acknowledges that a monopolist subject to rate regulation may well find it profitable to integrate vertically. Gaining control of a second, unregulated level of production would allow the firm to earn the profits foreclosed by regulators. In such cases, it is arguably appropriate to prohibit vertical integration in order to isolate and quarantine the monopolist. Such regulation is justified, however, only in cases of natural monopoly, where any attempt to break up the monopoly would ultimately prove futile. If the market at issue is not a natural monopoly, both rate regul equally unwarranted 6. The Critique of foreclosure Chicago ol supporters also debunked the notion that a firm without market power could use vertical integration to foreclose competitors. Suppose that a shoe manufacturer that controls a non- dominant share of total shoe manufacturing(say, ten percent)decides to integrate vertically into retail shoe stores and sell its shoes only through dedicated outlets. It cannot be said that the decision to integrate verticall has foreclosed any of the shoe manufacturers existing competitors, since hey still have available the number of shoe retailers (ninety percent) sufficient to allow them sell all of their available supply(ninety but it cannot limit the amount of the market available to rivals< percent) Vertical integration into retailing may realign the patterns of di 79 WILLIAM F SHUGHART IL, THE ORGANIZATION OF INDUSTRY 324(1990); McGee Bassett, supra note 72, at 22-32, 38: Pemy, supra note 72, at 192 supra note 68, at 809, 870n Bowman, supra note 70, at 21-23. For a detailed exposition of AT&Ts use of this form of lever harm competition for long distance telephony, see Timothy J. Brennan, Why Regulated Firms Should Be Kept Out of Unregulated Markets: Understanding the Divestiture in U.S.v. AT&T, 32 ANTITRUST BULL.741(1987) Brore& Those familiar with antitrust will recognize that this hypothetical is based on the facts of Shoe Co. v. United States, 370 U.S. 294(1962). 82 BORK, supra note 70, at 232: Sam Peltzman, Issues in Vertical Integration Policy, in PUBLIC POLICY TOWARDS MERGERS 167, 169-70(J. Fred Weston& Sam Peltzman eds, 1969). Posne and Easterbrook illustrate the ppose GM bought 10% of its gasket needs from each of 10 firms(A through ) that M purchased 10% of all gaskets sold in America, and that firms A through were of ual size. GM now purchases firm 4 and announces that it will buy its gasket equirements from A exclusively. Would B through J care? No. They still would have 90% of the nation,s gasket production capacity and would supply 90% of the market. The firms to which A used to ship 90% of its gasket output now would turn to the market and find B through J ready to supply that demand. The number of gaskets sold is unchanged; market shares are unchanged; only the patterns of sales are altered. POSNER EASTERBRook, supra note 68, at 870 191
Vertical Integration and Media Regulation in the New Economy 191 arguable that horizontal remedies will prove more effective in curbing it than any prohibition of vertical integration or vertical restraints.79 The second exception is more significant for the purposes of this Article. It acknowledges that a monopolist subject to rate regulation may well find it profitable to integrate vertically. Gaining control of a second, unregulated level of production would allow the firm to earn the profits foreclosed by regulators.80 In such cases, it is arguably appropriate to prohibit vertical integration in order to isolate and quarantine the monopolist. Such regulation is justified, however, only in cases of natural monopoly, where any attempt to break up the monopoly would ultimately prove futile. If the market at issue is not a natural monopoly, both rate regulation and the concomitant prohibition of vertical integration are equally unwarranted. b. The Critique of Foreclosure Chicago School supporters also debunked the notion that a firm without market power could use vertical integration to foreclose competitors. Suppose that a shoe manufacturer that controls a nondominant share of total shoe manufacturing (say, ten percent) decides to integrate vertically into retail shoe stores and sell its shoes only through dedicated outlets.81 It cannot be said that the decision to integrate vertically has foreclosed any of the shoe manufacturer’s existing competitors, since they still have available the number of shoe retailers (ninety percent) sufficient to allow them sell all of their available supply (ninety percent). Vertical integration into retailing may realign the patterns of distribution, but it cannot limit the amount of the market available to rivals.82 79 WILLIAM F. SHUGHART II, THE ORGANIZATION OF INDUSTRY 324 (1990); McGee & Bassett, supra note 72, at 22-32, 38; Perry, supra note 72, at 192. 80 BORK, supra note 70, at 376; POSNER & EASTERBROOK, supra note 68, at 809, 870 n.2; Bowman, supra note 70, at 21-23. For a detailed exposition of AT&T’s use of this form of leverage to harm competition for long distance telephony, see Timothy J. Brennan, Why Regulated Firms Should Be Kept Out of Unregulated Markets: Understanding the Divestiture in U.S. v. AT&T, 32 ANTITRUST BULL. 741 (1987). 81 Those familiar with antitrust will recognize that this hypothetical is based on the facts of Brown Shoe Co. v. United States, 370 U.S. 294 (1962). 82 BORK, supra note 70, at 232; Sam Peltzman, Issues in Vertical Integration Policy, in PUBLIC POLICY TOWARDS MERGERS 167, 169-70 (J. Fred Weston & Sam Peltzman eds., 1969). Posner and Easterbrook illustrate the point with the following numerical example: Suppose GM bought 10% of its gasket needs from each of 10 firms (A through J), that GM purchased 10% of all gaskets sold in America, and that firms A through J were of equal size. GM now purchases firm A and announces that it will buy its gasket requirements from A exclusively. Would B through J care? No. They still would have 90% of the nation’s gasket production capacity and would supply 90% of the market. The firms to which A used to ship 90% of its gasket output now would turn to the market and find B through J ready to supply that demand. The number of gaskets sold is unchanged; market shares are unchanged; only the patterns of sales are altered. POSNER & EASTERBROOK, supra note 68, at 870
Yale Journal on Regulation Vol.19:171.2002 In addition, the Chicago School argued that vertical integration between shoe manufacturers and shoe retailers cannot deter new entry unless there are barriers to entry protecting the shoe retailing market. This is because, even if the existing shoe manufacturers have locked up all of the existing shoe retailers, absent barriers to entry in retailing, any new shoe manufacturer seeking to find distribution should find distributors waiting to meet it C. Efficiency Justifications for Vertical Integration Having cast doubt on whether vertical integration could plausibly harm competition in the absence of monopoly power in the first market and barriers to entry protecting the second market, Chicago School scholars bolstered their campaign against the per se illegality of vertical integration by identifying several ways in which vertical integration could actually enhance efficiency. The two sources of efficiency most relevant to the purposes of this Article are the elimination of double marginalization resulting from successive monopolies and the reduction of transaction Elimination of Double Marginalization. Drawing on the pioneering work of Joseph Spengler, Chicagoans pointed out that vertical integration or restraints can be welfare-enhancing when successive stages o production are both controlled by monopolies. Chicago School scholars pointed out that this so-called"double marginalization"problem lead successive monopolies to set higher prices than would firms that used some vertical device to coordinate pricing decisions. It has now become generally accepted that vertical integration between successive monopolists is unambiguously welfare-enhancing RK, supra note 70, at 241; POSNER, supra note 69, at 197-98 GEORGE J STIGLER, THE ORGANIZATION OF INDUSTRY 113-22(1968), Director Levi, supra note 68, at 293 84 See Joseph J. Spengler, Vertical Integration and Antitrust Policy, 58 J. POL. ECON. 347 (1950), see also Fritz Machlup Martha Taber, Bilateral Monopoly, Successive Monopoly, and Vertical Integration, 27 ECONOMICA 101(1960)(reviewing the early scholarship on successive EASTERBROOK, supra note 68, at 875-76: Peltzman, supra note 82, at 171 n 3; see also Fishman v Estate of wirtz, 807 F 2d 520, 563(7th Cir. 1986)(Easterbrook, J, dissenting ). For useful discussions of the economic literature onopoly, see BLaIr KASERMAN TIROLE, supra note 24, at 174-77, and FREDERICK R. WARREN-BOULTON, VERTICAL CONTROL OF MARKETS 51-63, 80-82 n1 (1978). For useful discussions appearing in the legal literature, see HoVENKAMP, supra note 52,$9. 2c, at 374-77; and Chen Hylton, supra note 24, at 595-97, 631-3 TIROLE, supra note 24, at 177("WElfare is unambiguously increased by the elimination marginalization.); Roger D. blair Jeffrey L. Harrison, Antitrust Policy and CORNELL L. REV. 297, 328(1991)(The welfare effects of the monopsonist ackwar tegration are unambiguously positive. ) Chen Hylton, supra note 24, at 598 integration makes both the producers and consumers better off. ), see also Wirt 07 F 2d at 563(Easterbrook, J, dissenting)("Propositions about the economics of mergers often are 1
Yale Journal on Regulation Vol. 19:171, 2002 192 In addition, the Chicago School argued that vertical integration between shoe manufacturers and shoe retailers cannot deter new entry unless there are barriers to entry protecting the shoe retailing market. This is because, even if the existing shoe manufacturers have locked up all of the existing shoe retailers, absent barriers to entry in retailing, any new shoe manufacturer seeking to find distribution should find distributors waiting to meet it.83 c. Efficiency Justifications for Vertical Integration Having cast doubt on whether vertical integration could plausibly harm competition in the absence of monopoly power in the first market and barriers to entry protecting the second market, Chicago School scholars bolstered their campaign against the per se illegality of vertical integration by identifying several ways in which vertical integration could actually enhance efficiency. The two sources of efficiency most relevant to the purposes of this Article are the elimination of double marginalization resulting from successive monopolies and the reduction of transaction costs. Elimination of Double Marginalization. Drawing on the pioneering work of Joseph Spengler,84 Chicagoans pointed out that vertical integration or restraints can be welfare-enhancing when successive stages of production are both controlled by monopolies.85 Chicago School scholars pointed out that this so-called “double marginalization” problem leads successive monopolies to set higher prices than would firms that used some vertical device to coordinate pricing decisions. It has now become generally accepted that vertical integration between successive monopolists is unambiguously welfare-enhancing.86 83 See BORK, supra note 70, at 241; POSNER, supra note 69, at 197-98; GEORGE J. STIGLER, THE ORGANIZATION OF INDUSTRY 113-22 (1968); Director & Levi, supra note 68, at 293. 84 See Joseph J. Spengler, Vertical Integration and Antitrust Policy, 58 J. POL. ECON. 347 (1950); see also Fritz Machlup & Martha Taber, Bilateral Monopoly, Successive Monopoly, and Vertical Integration, 27 ECONOMICA 101 (1960) (reviewing the early scholarship on successive monopoly theory). 85 See BORK, supra note 70, at 229; POSNER, supra note 69, at 200-01; POSNER & EASTERBROOK, supra note 68, at 875-76; Peltzman, supra note 82, at 171 n.3; see also Fishman v. Estate of Wirtz, 807 F.2d 520, 563 (7th Cir. 1986) (Easterbrook, J., dissenting). For useful discussions of the economic literature on successive monopoly, see BLAIR & KASERMAN, supra note 24, at 31-36; TIROLE, supra note 24, at 174-77; and FREDERICK R. WARREN-BOULTON, VERTICAL CONTROL OF MARKETS 51-63, 80-82 n.1 (1978). For useful discussions appearing in the legal literature, see HOVENKAMP, supra note 52, § 9.2c, at 374-77; and Chen & Hylton, supra note 24, at 595-97, 631-32. 86 TIROLE, supra note 24, at 177 (“[W]elfare is unambiguously increased by the elimination of the double marginalization.”); Roger D. Blair & Jeffrey L. Harrison, Antitrust Policy and Monopsony, 76 CORNELL L. REV. 297, 328 (1991) (“The welfare effects of the monopsonist’s backward vertical integration are unambiguously positive.”); Chen & Hylton, supra note 24, at 598 (“In sum, vertical integration makes both the producers and consumers better off.”); see also Wirtz, 807 F.2d at 563 (Easterbrook, J., dissenting) (“Propositions about the economics of mergers often are
Vertical Integration and Media Regulation in the New Economy Again, the example involving the fabrication of copper ingot into copper pipe discussed above provides a useful illustration. Suppose that both the company that refined copper ore into ingot and the company that fabricated the ingot into pipe were both monopolists. As noted before, the cost of manufacturing the ingot was assumed to be $40. the cost of fabricating the ingot into pipe was $35, and the profit-maximizing price for pipe was $100. In an effort to capture all of the monopoly profit, the ingot monopolist would charge $65 for the ingot($40 in costs +$25 in available profit) and hope that the pipe fabricator will price at cost. The pipe fabricator will similarly attempt to capture all of the available profit by charging $60( $35 in costs $25 in available profit) and hope that the ingot manufacturer will price at cost. The result is that the final product will cost $125, a price driven well above profit-maximizing levels that would be in the self-interest of the two monopolists. Although both firms could increase the total profit available by agreeing on a way to reduce the final price, the fact that the firms are locked into a classic bilateral monopoly will render the terms of any such agreement indeterminate and greatly increase the likelihood of deadlock. Vertical integration would eliminate this problem, however, since the integrated entity would simply set the final price of the pipe at the profit-maximizing level of $100 without having to worry about the allocation of the monopoly profits between the two different stages of production Reduction of Transaction Costs. The Chicago School also contended that vertical integration could promote efficiency by reducing transaction costs. Some of these arguments followed the Coasean insight that integration can reduce the overall friction involved in organizing business enterprises by internalizing certain transactions within the firm. Others suggested that vertical integration can lead to efficiencies by allowing firms to avoid the transaction costs associated with protecting themselves against opportunistic behavior. In particular, the literature identifies at least three types of opportunistic behavior that firms may seek to avoid Hold Up. The landmark article by Benjamin Klein, Robert Crawford, and Armen Alchian identified a type of opportunistic behavior that can arise whenever a firm makes an investment that is uniquely tailored to the needs of the other when the cost of such an asset exceeds the value of its next-best use, the investment is said to create"appropriable quasi-rents, successive note 71 and accompanying text Taber supra note 84, at 105-06, 111-13: Wirt, 807 F2d at 563(Ea R H Coase, The Theory of the Firm, 4 ECONOMICA 386(1937) See BoRk, supra note 70, at 227 193
Vertical Integration and Media Regulation in the New Economy 193 Again, the example involving the fabrication of copper ingot into copper pipe discussed above provides a useful illustration.87 Suppose that both the company that refined copper ore into ingot and the company that fabricated the ingot into pipe were both monopolists. As noted before, the cost of manufacturing the ingot was assumed to be $40, the cost of fabricating the ingot into pipe was $35, and the profit-maximizing price for pipe was $100. In an effort to capture all of the monopoly profit, the ingot monopolist would charge $65 for the ingot ($40 in costs + $25 in available profit) and hope that the pipe fabricator will price at cost. The pipe fabricator will similarly attempt to capture all of the available profit by charging $60 ($35 in costs + $25 in available profit) and hope that the ingot manufacturer will price at cost. The result is that the final product will cost $125, a price driven well above profit-maximizing levels that would be in the self-interest of the two monopolists. Although both firms could increase the total profit available by agreeing on a way to reduce the final price, the fact that the firms are locked into a classic bilateral monopoly will render the terms of any such agreement indeterminate and greatly increase the likelihood of deadlock.88 Vertical integration would eliminate this problem, however, since the integrated entity would simply set the final price of the pipe at the profit-maximizing level of $100 without having to worry about the allocation of the monopoly profits between the two different stages of production. Reduction of Transaction Costs. The Chicago School also contended that vertical integration could promote efficiency by reducing transaction costs. Some of these arguments followed the Coasean insight89 that integration can reduce the overall friction involved in organizing business enterprises by internalizing certain transactions within the firm.90 Others suggested that vertical integration can lead to efficiencies by allowing firms to avoid the transaction costs associated with protecting themselves against opportunistic behavior. In particular, the literature identifies at least three types of opportunistic behavior that firms may seek to avoid. Hold Up. The landmark article by Benjamin Klein, Robert Crawford, and Armen Alchian identified a type of opportunistic behavior that can arise whenever a firm makes an investment that is uniquely tailored to the needs of the other. When the cost of such an asset exceeds the value of its next-best use, the investment is said to create “appropriable quasi-rents,” filled with ifs and maybes; competing schools of thought produce different prescriptions. That successive monopolies injure consumers is a proposition on which there is unanimous agreement.”). 87 See supra note 71 and accompanying text. 88 Machlup & Taber, supra note 84, at 105-06, 111-13; Wirtz, 807 F.2d at 563 (Easterbrook, J., dissenting). 89 R.H. Coase, The Theory of the Firm, 4 ECONOMICA 386 (1937). 90 See BORK, supra note 70, at 227
Yale Journal on Regulation Vol.19:171.2002 because they allow others to hold up the investing party in an attempt to extract a greater proportion of the joint benefits Firms confronting the risk of such opportunistic behavior essentially have two options. First, they can attempt to anticipate the problems and incorporate solutions to them into the contractual relationship Negotiating and enforcing such contracts can be quite costly, and the costs of protecting one's interests via contract rise dramatically as the size of the relationship-specific investment increases and as information becomes increasingly asymmetric and hard to verify. These proble exacerbated still further if the risks associated with the project are high and the number of alternative business partners is relatively small. In addition, the il ng every possible inevitably means that all contracts are in some way analytically incomplete. At some point, transaction costs may rise to the point wher they frustrate the parties'ability to reach a mutually beneficial bargain When this occurs, the firms may find it beneficial to solve the problem through vertical integration. Bringing the two firms under the same corporate umbrella eliminates the incentives for engaging in opportunistic behavior designed to affect the division of profits between the two firm The firms can then give their undivided attention to determining the combination of resources that maximizes joint profits and, as a result, maximizes total welfare 94 The classic example discussed in the literature iS GMs 1926 acquisition of one of its component manufacturers, Fisher Body 95 According to Klein, Crawford, and Alchian, the shift from wooden to metal automobile bodies required Fisher Body to make investments in new metal stamping technology unique to GMs cars. Under the Klein- Crawford-Alchian framework, the existence of such relationship-specific investments raised the danger that Gm would act opportunistically against Fisher Body after the investment costs had already been sunk. To mitigate this risk, GM and Fisher Body entered into a long-term exclusive dealing agreement in which the price was set at operating costs plus a substantial 91 Benjamin Klein, Robert G. Crawford, Armen A. Alchian, Vertical Integration, Appropriable Rents, and the Competitive Contracting Process, 21 J. L& ECoN. 297, 298(1978) 92 ld. at 302-07; see also PoSNER EASTERBROOK, supra note 68, at 886("LOng term exclusive dealing contracts may be an effective way of dealing with opportunistic behavior. 93 See WILLIAMSON, supra note 24, at 22-24, 28-29; Chen Hylton, supra note 24, at 590- 94 OLIVER E. WIILLAMSON, THE ECONOMIC INSTTTUTIONS OF CAPITALISM 48-49(1985); aul L Joskow, Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric Generating Plants, 1 J. L. ECoN. ORG. 33, 37(1985); Klein et al, supra note 91, at 302-04 see also Chen hylton 59 note 72. at 214 95 Klein et al, supra note 91, at 308-10 For a discussion of the seminal place that the Fisher Body case has taken in the literature, see Daniel F. Spulber, Economic Fables and Public Policy, in FAMOUS FABLES OF ECONOMICS 15-18(Daniel F Spulber ed, 2002). 194
Yale Journal on Regulation Vol. 19:171, 2002 194 because they allow others to hold up the investing party in an attempt to extract a greater proportion of the joint benefits.91 Firms confronting the risk of such opportunistic behavior essentially have two options. First, they can attempt to anticipate the problems and incorporate solutions to them into the contractual relationship.92 Negotiating and enforcing such contracts can be quite costly, and the costs of protecting one’s interests via contract rise dramatically as the size of the relationship-specific investment increases and as information becomes increasingly asymmetric and hard to verify. These problems are exacerbated still further if the risks associated with the project are high and the number of alternative business partners is relatively small.93 In addition, the impossibility of anticipating every possible contingency inevitably means that all contracts are in some way analytically incomplete. At some point, transaction costs may rise to the point where they frustrate the parties’ ability to reach a mutually beneficial bargain. When this occurs, the firms may find it beneficial to solve the problem through vertical integration. Bringing the two firms under the same corporate umbrella eliminates the incentives for engaging in opportunistic behavior designed to affect the division of profits between the two firms. The firms can then give their undivided attention to determining the combination of resources that maximizes joint profits and, as a result, maximizes total welfare.94 The classic example discussed in the literature is GM’s 1926 acquisition of one of its component manufacturers, Fisher Body.95 According to Klein, Crawford, and Alchian, the shift from wooden to metal automobile bodies required Fisher Body to make investments in new metal stamping technology unique to GM’s cars. Under the KleinCrawford-Alchian framework, the existence of such relationship-specific investments raised the danger that GM would act opportunistically against Fisher Body after the investment costs had already been sunk. To mitigate this risk, GM and Fisher Body entered into a long-term exclusive dealing agreement in which the price was set at operating costs plus a substantial 91 Benjamin Klein, Robert G. Crawford, & Armen A. Alchian, Vertical Integration, Appropriable Rents, and the Competitive Contracting Process, 21 J.L. & ECON. 297, 298 (1978). 92 Id. at 302-07; see also POSNER & EASTERBROOK, supra note 68, at 886 (“[L]ong term exclusive dealing contracts may be an effective way of dealing with opportunistic behavior.”). 93 See WILLIAMSON, supra note 24, at 22-24, 28-29; Chen & Hylton, supra note 24, at 590- 91. 94 OLIVER E. WIILLAMSON, THE ECONOMIC INSTITUTIONS OF CAPITALISM 48-49 (1985); Paul L. Joskow, Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric Generating Plants, 1 J.L. ECON. & ORG. 33, 37 (1985); Klein et al., supra note 91, at 302-04; see also Chen & Hylton, supra note 24, at 591; Perry, supra note 72, at 214. 95 Klein et al., supra note 91, at 308-10. For a discussion of the seminal place that the Fisher Body case has taken in the literature, see Daniel F. Spulber, Economic Fables and Public Policy, in FAMOUS FABLES OF ECONOMICS 15-18 (Daniel F. Spulber ed., 2002)