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Does Contract Complexity Limit Opportunities? Vertical Organization and Flexibility

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  • Pennings, H.P.G.

Abstract

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.

Suggested Citation

  • Pennings, H.P.G., 2010. "Does Contract Complexity Limit Opportunities? Vertical Organization and Flexibility," ERIM Inaugural Address Series Research in Management EIA-2010-044-STR, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam..
    • Handle: RePEc:ems:euriar:20457
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    contract theory; firm value; flexibility; outsourcing; real options; vertical organization;
    All these keywords.

    JEL classification:

    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • L20 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - General
    • M - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics

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