Does Contract Complexity Limit Opportunities? Vertical Organization and Flexibility
The vertical organization of production entails a range of make-or-buy decisions of intermediate goods that are influenced by the difficulty of writing contracts with a potential supplier. When contracting causes high transaction costs, a firm can decide to vertically integrate the production of the intermediate product. Contract complexity can be measured by decomposing the range of inputs into inputs that are traded on an exchange (low contract complexity), inputs for which reference prices exist (low to medium contract complexity) and other, often relationship-specific inputs (medium to high contract complexity). This inaugural lecture addresses the impact of contract complexity on the growth opportunities of a firm. The present value of growth opportunities are embedded in the market value of a firm, which is a multiple of the firm’ stock price. Examining the relation between the growth opportunities as part of the market value and contract complexity, we find that contract complexity has a negative impact on the growth opportunities of a firm if vertical integration is difficult. Whereas, on average, growth opportunities account for 56% of the market value of a firm, this percentage ranges between 50% and 53% for firms in sectors where contracts are complex and vertical integration is difficult. The difference represents a current market value between € 12 bn. and € 24 bn. only taking into account Dutch listed firms.
|Keywords||contract theory, firm value, flexibility, outsourcing, real options, vertical organization|
|Publisher||Erasmus Research Institute of Management (ERIM)|
|Sponsor||Erasmus School of Economics (ESE) Erasmus University Rotterdam|
Pennings, H.P.G. (2010, September 17). Does Contract Complexity Limit Opportunities? Vertical Organization and Flexibility. ERIM report series research in management Erasmus Research Institute of Management. Erasmus Research Institute of Management (ERIM). Retrieved from http://hdl.handle.net/1765/20457