Vertical Integration and the Informational Content of Prices

1 March 2010 at 11:19 am 13 comments

| Peter Klein |

Many years ago, when I was taking Williamson’s Economics of Institutions class at Berkeley and fishing around for dissertation topics, I had the idea to do some empirical work on the relationship between inflation and vertical integration or conglomerate diversification. The basic idea is that monetary expansion not only raises price levels, but also increases the dispersion of relative prices — introducing “noise” into the price mechanism — giving entrepreneurs an incentive to internalize transactions, on the margin, they would have otherwise conducted in the market. My interest was partly piqued by an off-hand remark by Dick in a review of Chandler’s Scale and Scope:

Things began to go wrong in the 1960s with the wave of conglomerate diversification, that is, with diversification by companies into areas wholly unrelated to their “core competence.” ITT was the paradigm of this phenomenon. Originally an international maker of telephone switching equipment, it bought, among other things, an insurance company and the maker of Hostess Twinkies. Chandler sees this as an inefficient practice, with many of the disbenefits of overextended British personal capitalism. There is no historical precedent for such unrelated diversification, he notes, except for German Konzerne during the hyperinflation of the 1920s. What is interesting — and what Chandler doesn’t mention — is that it is precisely inflation, in this case the Lyndon Johnson inflation of the 1960s, to which many have pointed as the cause of the wave of conglomerate mergers. The conglomerate is in effect an “internal capital market” that invests in a diversified portfolio of unrelated interests. But why? The stock market is much better at diversifying away risk than is such an arrangement, and it has many other advantages as well. In a time of inflation, the argument goes, price signals become distorted as managers find it difficult to disentangle changes in relative prices (that is, real prices) from changes in the price level. In such a world, the internal information and control within a conglomerate may have advantages that outweigh the disadvantage.

But, in any case, the trend in the less-inflationary 80s was the opposite one, the breaking apart of corporate holdings. . . .

The idea that conglomerate diversification, and “hierarchies” more generally, are responses to conditions in external markets has proven very useful in my own work; it also appears in Amar Bhidé’s neglected 1990 paper on diversification. Dick’s review cites a 1989 paper by Don Boudreaux and Bill Shughart linking US inflation rates and a measure of vertical integration but I couldn’t find such a relationship for diversification, and ended up going in a different direction.

My interest has been rekindled, however, by a couple of papers from Bob Gibbons, Richard Holden, and Michael Powell, “Rational-Expectations Equilibrium in Intermediate Good Markets” and “Integration and Information: Markets and Hierarchies Revisited.” These papers combine an incomplete-contracting model à la Grossman and Hart (1986) with various price-information models in the spirit of Grossman and Stiglitz (1980). Let me quote from the introduction to the second paper:

[W]hile Coase was explicit that the “price mechanism” is the chief alternative to internal organization, and Williamson’s (1975) title famously emphasized “Markets”as the alternative to hierarchy, over the next 35 years, the market disappeared from the literature on …firms’ boundaries. Instead, the literature focused on non-integration versus integration at the transaction level, rather than the functioning of the price mechanism at the market level.

Omitting the price mechanism from the theory of the …firm could be problematic. In particular, suppose (as seems plausible in the world and is being explored in a growing theoretical literature) that agents choose fi…rm boundaries and internal control structures in part to affect incentives to gather and communicate information. Agents’ interests in choosing governance structures to strengthen these incentives will depend in part on how well market prices already perform this function. For example, if market prices are very informative, then agents will choose governance structures to improve incentives for other activities (say, cost reduction), effectively free-riding on the informativeness of the price mechanism. On the other hand, as Grossman and Stiglitz (1980) noted long ago, if everyone free-rides, then there will not be any information in prices. Thus, analyzing the choice between integration and non-integration for one dyad in isolation (rather than in the context of a market of analogous dyads making analogous choices) potentially commits two errors. First, each dyad takes the informativeness of the price mechanism as an important parameter in its choice of governance structure, but this parameter is hard to discern in most models of the integration decision. And second, this important parameter is endogenous: agents’ governance-structure decisions affect the informativeness of the price mechanism.

We view fi…rms and the market not only as alternative ways of organizing economic activity, but also as institutions that shape each other. In this paper we explore how the informativeness of the price mechanism and …firms’ integration decisions interact. To do so we analyze an economic environment that includes uncertainty. Formally, the uncertainty concerns consumers’ valuation of …final goods, but we discuss other interpretations below. Parties can resolve this uncertainty at a cost. As in other rational-expectations models, the price mechanism both clears the market and conveys information from informed to uninformed parties. The fact that the price is not perfectly informative provides the requisite incentive for some parties to pay the cost to resolve the uncertainty.

Of course, this way of modeling uncertainty and the information content of prices doesn’t capture the Hayekian concept of tacit knowledge (Thomnsen, 1992; Kirzner, 1997, pp. 60-85), but the exercise is informative and highly recommended for students of the theory of the firm.

Entry filed under: - Klein -, New Institutional Economics, Strategic Management, Theory of the Firm.

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13 Comments Add your own

  • 1. Warren Miller  |  1 March 2010 at 2:22 pm

    Great stuff, as always, Peter.

    Dick’s assertion that ITT was the paradigm of conglomerate diversification overlooks a company that made ITT look like a piker: the old Beatrice Foods company. Before its takeover in 1986 and subsequent lightning-fast liquidation by KKR, Beatrice had these food brands/businesses under its roof: Tropicana juices, Hunt’s Ketchup, Esmark/Swift, and La Choy Chinese food. So far, so good. But, in the tradition of Veg-o-Matic, “Wait, there’s more!” beneath that corporate umbrella. Here it is: Samsonite luggage, Stiffel lamps, Bonanza motor homes, All-Pro leisure apparel, Day-Timers, Avis, Best Jet painting equipment, World Dryer hand dryers, Byron’s barbecue equipment, Culligan water treatment, A.H.Schwab sandboxes and peg desks, Aqua Queen garden equipment, Airstream, and, fasten your seatbelts, Playtex lingerie. In just 16 months, KKR investors made $3B on an investment of $416 million. KKR and other groupies reaped another $250 million in fees. Aren’t inefficient markets great?!

  • 2. Peter Klein  |  1 March 2010 at 6:29 pm

    Warren, sounds like another entry for our “Corporate Diversification Humor” post:

  • 3. David Gerard  |  2 March 2010 at 12:46 pm

    Herb Simon discusses this puzzle about vertical integration and prices briefly in his 1991 JEP piece. :

    Prices perform their informational function when they are known or reasonably predictable. Uncertain prices produced by unpredictable shifts in a system reduce the ability of actors to respond rationally.This point is often made by economists in arguing the costs of unexpected inflation, but its implications for the choice between organizations and markets is less often noted. Nor is it often noted that many kinds of uncertainties other than price uncertainties may make coordination through organizational procedures advantageous.

  • 4. Peter Klein  |  2 March 2010 at 12:50 pm

    Thanks David, I missed that passage!

  • 5. David Hoopes  |  2 March 2010 at 10:01 pm

    I like teaching General Mills cases. One was a staple of the UCLA MBA program when I was a doctoral student there. General Mills owned Izod, Star Wars figurines, some electronic games, Eddie Baur, Red Lobster, and The Limited in the early 1980s. I’ve probably forgotten a few. I think in the 1960s they were even more “diversified.”

  • 6. Frederic Sautet  |  2 March 2010 at 10:04 pm

    Interesting post indeed. Thanks for this insight.
    I was wondering if this could also find its parallel in anti-trust activity. In situations of inflation, by the same logic, one may see more attempts at “cooperation” in the market. This may give rise not only to vertical integration, but also perhaps to price fixing and cartel type behavior (forms of horizontal integration). This would explain the high level of anti-cartel activity in the 1960s-1980s for instance. Although it is still happening today in a relatively low inflationary environment. Just a thought.

  • 7. Recomendaciones « intelib  |  3 March 2010 at 12:21 pm

    […] Vertical Integration and the Informational Content of Prices, by Peter Klein […]

  • 8. Peter Klein  |  4 March 2010 at 12:08 am

    Good question, Frederic. One could view cartels, price-fixing arrangements, etc. as “hybrids,” in the Williamsonian sense, and argue that relative price variability provides a rationale for hybrids as well as hierarchies.

  • 9. Arend  |  5 March 2010 at 6:50 am

    Interesting post!

    “We view fi…rms and the market not only as alternative ways of organizing economic activity, but also as institutions that shape each other.”

    I understand the difference between hierarchies and orders; or taxis and comos; but I cannot get my mind around the claim that these are fundamentally different institutions, or even *alternative* ways of organizing economic activity. Orders are not organized and are the result of hierarchies which are organized; that is the whole (Menger-Hayekian) point. Resultants from orders, such as prices can represent information (subjective judgment) to hierarchies whether their integration is economically viable or not.

    Comparing and contrasting these institutions, so to say, must lead to the conclusion that hierarchies and orders are instances of the same institution namely, exchange under the division of labor and private property: the free enterprise market economy. The only fundamental contrast exists between this kind of economic organization (including both hierarchy and order) and alternative kinds like interventionism or socialism. In this sense the loss of the price mechanism in the theory of the form is indeed lamentable since it effectively neglects one side of the coin.

    See also: Mathews, QJAE 1.3, 1998

  • 10. Peter Klein  |  5 March 2010 at 9:54 am

    Arend, yes, I agree with you completely. Markets and hierarchies are substitutes in the limited sense that one can organize a particular transaction in-house or on the open market (or via an intermediate form, etc.). But both organizational forms operate within a larger institutional context (private property, the price mechanism, and so on). Indeed, “designed orders” (i.e., firms) can only be economically efficient when they compete against other designed orders — otherwise we are back to the One Big Firm question posed in Coase 1937. I discuss this a little in my 1996 RAE article on economic calculation.

  • 11. Dick Langlois  |  8 March 2010 at 10:53 am

    Thanks, Peter. You provided me with a new assignment for my organization course.

  • 12. Peter Klein  |  8 March 2010 at 11:46 am

    I’m putting this on my annual report under “Teaching Accomplishments”! ;-)

  • 13. David Gerard  |  16 March 2010 at 10:09 am

    Can you post the answer?

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