Does contract complexity limit opportunities? Vertical organisation and flexibility
On Friday, September 17, 2010, Enrico Pennings presented his inaugural address entitled “Does contract complexity limit opportunities? Vertical organisation and flexibility”. The focus of this lecture was on the impact of contractual complexity on the option value of growth opportunities. The lecture integrated an important research topic in industrial organisation and strategy (the vertical organisation of production) with recent advances in real options. The main result is the lower value of growth opportunities for firms which face difficulties with writing contracts to outsource complex inputs or vertically integrate these inputs.
About Enrico Pennings
Enrico Pennings is endowed professor in Applied Industrial Economics, Department of Applied Economics, Erasmus School of Economics. His chair is endowed by the Erasmus University Trust Fund. He obtained his PhD in 1998 (cum laude) from the Erasmus University Rotterdam with a thesis entitled "Real Options and Managerial Decision Making". Since 2005 he is fellow of the Tinbergen research school and since 2006 member of the ERIM research school. From 1999 to 2001 Dr. Pennings was assistant professor at the University Pompeu Fabra (Barcelona) and from 2001 through 2004 he was an IGIER fellow and assistant professor at IGIER-Bocconi University (Milano).
Abstract of the Inaugural Address
The vertical organisation 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’s 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.
More information
Enrico Pennings
Full text of the inaugural address
Photos of the Inaugural Address
