In the vast literature on firm organisation, external institutions are well known to shape a firm’s organisational decisions, i.e. the choice between arm’s length contracts (‘buy’) or vertical integration (‘make’). The focus so far has been on contract enforcement in the case of tangible assets, with most empirical evidence supportive of the so-called ‘property rights’ theory of the firm (Grossman and Hart 1986, Hart and Moore 1990). According to this view, firms rely on outsourcing to create investment incentives for suppliers when contracts are incomplete.
A new wave of empirical studies has started to highlight the role of intangible assets on firm organisation. Atalay et al. (2014) show that vertical integration is associated with a limited flow of physical inputs from upstream to downstream production stages, suggesting that it is used as a means to secure the efficient transmission of knowledge along the value chain. Better quality of intellectual property rights (IPR) institutions in host countries further facilitate knowledge transmission by multinationals to their affiliates (Branstetter et al. 2006). However, stronger IPR institutions shift the organisational mode towards outsourcing by reducing the need for integration to hedge against knowledge dissipation and opportunistic behaviour by the supplier (Kukharskyy 2019).
Starting from tangible ‘property rights’
Taken together, all these facts seem to suggest that the validity of the ‘property rights’ theory is somewhat limited to institutions affecting tangible property rights only. In contrast, a different approach, in line with the traditional ‘transaction cost’ theory of Williamson (1985), applies for the case of institutions affecting intangible assets. In other words, while weaker contracting institutions call for incentive provision through outsourcing, weaker IPR institutions in the location of production call for vertical integration as a shield against knowledge dissipation.
In a recent paper (Bolatto et al. 2019), we embed intellectual property into the ‘property rights’ theory of firm organisation, where both hold-up and knowledge dissipation can be present, regardless of the mode of organisation. The idea builds on work by Antràs and Chor (2013) and its subsequent extension by Alfaro et al. (2019), in which the supply chain is represented in form of a sequential production process consisting of several stages. At any stage, a supplier undertakes a relation-specific investment for the provision of a fully customised input, further reprocessed at the next stage. As supply contracts are incomplete, the firm has to decide which stages to outsource and which to integrate in order to deal with potential underinvestment related to hold-up. They face a tradeoff between incentive provision through outsourcing and rent extraction through integration.
Two possible patterns arise depending on industry characteristics: the final demand elasticity (i.e. the extent to which the firm controlling the value chain has market power over the final product) compared to the degree of physical input substitutability (i.e. the extent to which the firm can compensate underinvestment at a given stage through additional investment at other stages). When final demand is relatively elastic, prior upstream investments increase the marginal return to subsequent investments, raising the incentives for downstream suppliers (investments are sequential complements). The organisation choice obeys a cut-off rule, such that upstream stages are outsourced while downstream ones are integrated. The opposite pattern holds when the demand is more rigid, with supplier investments that are sequential substitutes.
Bringing in ‘intellectual’ property rights
Bolatto et al. (2019) investigate the effect of changes in the quality of IPR institutions on the organisational decisions along the supply chain by an additional choice a firm has to make at all stages. On top of the hold-up problem, the firm must transmit knowledge to its suppliers to facilitate their activity (more knowledge transmission makes input better suited to the firm’s specific needs). To avoid knowledge dissipation, the firm has to protect the transmitted intangibles, the cost of which increases with the knowledge intensity of the input produced by each supplier, and decreases with the quality of IPR institutions in supplier locations. It follows that imperfect IPR protection reduces the amount of knowledge transmitted by the firm to a supplier, affecting the organisation decision through the incentive structure of suppliers’ investments induced by the sequential nature of production.
New empirical evidence
We use a comprehensive dataset on the population of Slovenian firms in 2007-2010, obtained by merging their transaction-level trade data with their outward cross-border foreign direct investment, additional financial data, and input-output relations. We use this data to test how the strength of IPR institutions affects a firm’s probability of transacting an input within its boundaries, depending on the input knowledge intensity, and its position along the supply chain.
The results start from the premise presented by Antràs and Chor (2013): under perfect IPR protection, firms are more likely to outsource upstream when investments are sequential complements and integrate if they are sequential substitutes. Our findings reveal that IPR institutions are an important factor in the organisational decision of firms in industries in which inputs are sequential complements. Imperfect IPRs reduce knowledge transmission, with a substantial impact on the knowledge intensive side of the value chain. If downstream stages are heavily affected, the firm increases its instances of integration to compensate for forgone rents. If instead upstream stages are knowledge intensive then the propensity to outsource increases to compensate for the depressed incentives to invest along the value chain.
Figures 1 and 2 summarize the impact of IPR improvements on firm integration decisions for sequential complements, distinguishing between industries with knowledge concentrated in upstream and downstream stages. Figure 1 shows the average marginal effects of better IPR protection on the likelihood of integrating a supplier, while Figure 2 depicts the resulting changes in the incidence of outsourcing and vertical integration. Consider the case when knowledge intensive inputs are concentered upstream (right panel in Figures 1 and 2). Under weak IPR institutions, the firm compensates for less knowledge transmission upstream by extending the number of outsourced stages at the beginning of the supply chain. The reverse happens when inputs are more knowledge intensive downstream (left panel in Figures 1 and 2), where weak IPRs prompt a firm to start extracting more rent at an earlier stage by means of integration.
Figure 1 Average marginal effects of IPR improvements on the likelihood of vertical integration at different stages of the supply chain (sequential complements)
Source: Bolatto, Naghavi, Ottaviano and Zajc Kejžar (2019)
Figure 2 Firm boundary choices under weak and strong IPRs along the supply chain for sequential complements
The analysis also reveals that better institutions in supplier locations have opposite effects on firm organisation depending on whether they improve the protection of tangible or intangible assets. Given industry characteristics, when using ‘rule of law’ (i.e. a measure of the quality of contracting institutions) instead of ‘IPR quality’, the estimated coefficient is always opposite in sign, indicating that our findings are specific to institutions specifically affecting intellectual property. This distinctive effect of the quality of IPR protection is important in industries where inputs are sequential complements, but much less so in those where inputs are sequential substitutes.
What can be concluded in view of nations hosting different stages of production? In Bolatto et al. (2019), we shed new light on knowledge transmission from a headquarter firm to suppliers along its value chain. If a country improves the quality of its IPR institutions, it will induce changes in the organisation of the more knowledge-intensive stages of production, in particular in industries faced with relatively high demand elasticities (i.e. sequential complements). As shown in Figure 2, the impact is not uniform with respect to the supply chain position of knowledge-intensive inputs; favouring outsourcing in industries where these inputs concentrate downstream, and vertical integration in industries where they are upstream.
This has relevant policy implications in industries where investments are complementary along the value chain. If the aim is to promote knowledge transmission beyond the boundaries of large companies such as multinationals, better IPR protection can achieve this in countries specialised in industries with knowledge-intensive inputs concentrated downstream (left panel in Figure 2). IPR protection instead enhances knowledge transmission within the boundaries of multinational firms by promoting integration of knowledge intensive inputs when these are located upstream (right panel in Figure 2).
From a broader perspective, our work shows that IPR institutions bear heterogeneous impacts on the organisation of global supply chains across different industries. Furthermore, our results highlight the importance of distinguishing between institutions that protect tangible versus intangible assets. In particular, it suggests that, due to their opposite effects, simultaneous improvements in the protection of tangible and intangible assets may have an ambiguous net impact on the relative incidence of outsourcing and integration.
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Atalay, E, A Hortacsu and C Syverson (2014), “Vertical Integration and Input Flows", American Economic Review 104 (4): 1120-1148.
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