The Limits of Firms: Acquisition of a Supply Stage in Which Ownership and Management Are Separated

Suppose, arguendo, that vertical integration of the kind described above experiences the incentive disabilities that are ascribed to it. It is nevertheless noteworthy that the conditions described above are very special. In particular I have assumed that ownership and management are joined in the preacquisition supply stage. What if that condition does not obtain?

Suppose that an independent supplier undergoes an ownership change before an acquisition of the supplier is even contemplated. Suppose, in partic- ular, that what had been a closely held, owner-managed firm becomes a diffusely held firm in which none of the management has a significant equity interest.

The hazards of using high-powered (net receipt) incentives to compensate the management of this firm will be evident to owners and managers alike. Owners will recognize the asset dissipation hazards, and managers will be concerned that owners will retain influence over accounting, thus posing a risk that net receipt realizations will be manipulated: When those consequences are foreseen, high-powered incentives in this now diffusely owned firm will give way to incentives of a lower-powered kind. Salaried compensation will therefore obtain.

The critical question is whether, in view of the above-described changes that attend the change in ownership of the premerger supply stage, merger incurs any added costs. If it does not, then the acquisition by a purchasing stage of a supply stage in which the ownership has already been sold off would offer the prospect of gain without cost. The gains would presumably take the same form as those ascribed to merger previously: Subgoal pursuit by the supply stage management would be attenuated, so that coordination between the two stages would be accomplished more easily and effectively in the postmerger period when common ownership obtains.

The firm size dilemma to which I referred at the outset would then be restored with only a minor change. The puzzle would now read as follows: Why are not all diffusely owned production stages placed under unified ownership., thereby to be organized and operated as one large firm? Unless undisclosed costs of merger are discovered, we are mainly back where we started. Put differently, section 2 is an explication of the Berle and Means problem and does not provide an explanation for limits on vertical integration outside of that special context.

Unremarked merger consequences of three kinds warrant consideration. For one thing, to observe that ownership and management are separated does not establish that ownership is thereafter wholly lacking in control. Differential control effects within merged and nonmerged entities is thus one possibility. Second, the fact that managements in both pre- and postmerger regimes are salaried does not necessarily imply that compensation is disconnected from net receipts. Finally, the possibility that integration affects the internal politics of the corporation with systematic performance consequences warrants scrutiny. The first two consequences are considered here. The third is addressed in section 4.

1. Ownership Effects 

The absence of continuous (hands-on) control permits those to whom decision powers are delegated to exercise discretion. But a total absence of control is not thereby implied. To the contrary, if ownership control is reasserted when performance approaches or falls below threshold standards, then the relevant questions are ones of thresholds and competence to intervene. Ceteris paribus, weak standards imply greater opportunities for managerial discretion. Ownership interests are commonly activated, however, before bankruptcy becomes imminent.

The issues here are akin to those that arise in the M-form corporation, where operating and strategic decisions are separated. Thus even if, as discussed in Chapter 11, middle managers are “ostensibly” free from oversight during the operating interval, the absence of oversight should not be implied if (1) strategic management can and does intervene when a crisis occurs—which is to say, when the “essential variables” fall outside of prescribed limits— and (2) the operating plans are periodically renegotiated (say, at annual budget review intervals).

Albeit attenuated, the ownership bears a similar oversight relation to the strategic management. The relevant comparative institutional question is whether differential performance between integrated and nonintegrated regimes arises on that account. The main difference, if there is one, is that ownership oversight generally operates on more aggregate performance measures. Divisional performance thus generally escapes scrutiny. A tradeoff thus obtains whereby ownerhip oversight at the divisional level is somewhat less intensive in the integrated regime. The issues here, however, relate mainly to the costs of bureaucracy and are treated more fully in section 4.

2. Contingent Compensation 

The compensations of salaried managers and other employees who work for wages are ostensibly disconnected from performance. That is superficial, however, if in fact salaries are adjusted at contract renewal intervals and promotions are made with reference to past or promised performance. More generally, to model the employment relation entirely with reference to piece rate/flat rate distinctions is warranted only if intertemporal reputation and commitment features are absent (or are otherwise constant) across such classi- fications. That is rarely the case.


Assume that salary tracks reported net receipts with a lag. The question then is whether the net receipts of the supply division are independent of the pre- and postmerger status. One possible difference is that the postmerger management of the supply division may be more subject to accounting manip- ulation of reported net receipts than was the same management when the firm was an independent supplier. If, as seems plausible, the managers in the acquiring stage have a greater postmerger say over the accounting procedures, then net receipts in the postacquisition period will be tilted in the acquiring stage’s favor. Transfer prices in the postmerger regime are apt to be (com- paratively) distorted as a result.


If promotions are made not on the basis of seniority, rotation, a coin toss, or some other event over which the managers have no discretionary control, then the way in which the promotion process operates in the pre- and postmerger periods also warrants examination. Merger can effect promotions in two respects: Promotions within the supply stage may be made on a different basis as a result of the merger; and promotions out of the supply stage into the management of the combined entity now become feasible. If the postmerger promotion process becomes more highly politicized in either or both of those respects, the fact of salaried compensation in both pre- and postmerger regimes does not constitute incentive neutrality.

That managers playing in the larger (postmerger) game will conduct themselves differently from their behavior in the smaller (premerger) game is, at very least, plausible. Thus whereas promotions might be expected to go to those who presented themselves as effective advocates at the trading interface in the premerger period, the advantage is more apt to accrue to those who are effective conciliators postmerger. Chester Barnard’s remarks are apposite:

The general method of maintaining an informal executive organization is so to operate and select and promote executives that a general condition of compatibility of personnel is maintained. Perhaps often and certainly occasionally, men cannot be promoted or selected, or even must be relieved, because they cannot function, because they “do not fit,” where there is no question of formal competence. [1938, p. 224]

To be sure, efforts can be made to insulate the promotion process from those effects. For example, managers in the supply division might be advised that they are ineligible for promotion to the general office. But such a policy may be ineffective and/or ill-advised. Ineffectiveness will result if such policies are unaccompanied by credible commitments. Adverse side effects will occur if such policies engender resentment. Beyond that, moreover, is the question of whether, even if supply stage managers are denied advancement, they are m a position to delay or even block the promotion of others.

The upshot is that promotion differences between the nonintegrated and integrated regimes are unavoidable. If the promotional balance is tilted away rom mem in favor of politics in the process, which would appear to be the likely result, incentive impairments in the postmerger condition will ob- in. in which event, the adaptive benefits that integration potentially affords notwithstanding, integration is always attended by added costs. Selective intervention—gain without cost—is simply not a member of the feasible set.

Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.

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