Levels of asset specificity in relational contracting

Abstract

Standard property rights theory (whether static or dynamic) assumes assets are specific, but once this assumption is in place, the level of asset specificity has no bearing on the make-or-buy decision. While there are good reasons to doubt the universality of transaction cost economics’ prediction that the more specific the asset, the more likely is vertical integration to be optimal, this is an issue that cannot be addressed within the existing property rights framework. In this paper the level of asset specificity matters for the integration decision, even in the static version of the model, and this result emerges naturally once an equally reasonable bargaining protocol is considered. To show this, we take Baker, Gibbons, and Murphy’s (2002) relational contracting model, and use it as the vehicle for the analysis. Changing the bargaining protocol assumed by those authors results in a model in which the integration choice is affected in a non-trivial way by realized asset specificity.