An Empirical Study on Contractual Heterogeneity within the
Firm: The "Vertical Integration - Incentive Contracts" Mix
Luisa Affuso, Brunel University
This paper tests a discrete choice model explaining the adoption of a
mix of different contracts among firms. More specifically, it looks at
the contemporaneous adoption of vertical integration and franchise
contracts in the retailing industry. Such contractual heterogeneity has
been explained by the existing literature as due to heterogeneous
characteristics of the downstream outlets of the company. However,
such literature has proved unable to explain the phenomenon in that
its predictions generally contrast with what is observed in reality.
Indeed anecdotal evidence suggests that the existing theory may not have
captured the motivations for "contract mixing". The goal of this
study is to attempt to fill this void by seeking verification of some
original hypotheses, by comparing and contrasting them to the
established theories. The explanation suggested in this paper, supported
by outlet level microdata collected in a survey of UK firms, shows that
contract mixing represents a "separating equilibrium" in the principal
(upstream) agent (downstream) game. Such game takes place in a
framework characterized by the presence of uncertainty about the
state of demand in the market and asymmetric information. The
informational asymmetry is of the hidden action and hidden information
type, giving rise to potential problems of moral hazard and adverse
selection. The results provided by the probit models adopted show that
this organizational structure is an "optimal choice" for both
principal and agents. It is optimal for the principal in that
it provides the first best outcome in the trade-off between incentives
and risk sharing, while overcoming both the moral hazard and adverse
selection problems by generating a self-selection mechanism of the
agents. At the same time it proves to be optimal by providing the
maximum level of utility to heterogeneous agents.
Key Words: firm organization, vertical integration,
franchise contracts, uncertainty, discrete choice models
JEL Classification: L22, L42, D82, C35