Barrie R. Nault University of Calgary
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1 RELATIVE IMPORTANCE, SPECIFICITY OF INVESTMENTS AND OWNERSHIP IN INTERORGANIZATIONAL SYSTEMS Kunoo Han and Roert J. Kauffman Univerity of Minneota {khan, Barrie R. Nault Univerity of Calgary INTRODUCTION Worldwide BB e-commerce revenue are expected to reach $.7 trillion y the end of 004. At the center of thi dramatic growth are interorganizational information ytem (IOS), which are information ytem (IS) that facilitate the exchange of product, ervice and information etween firm. Example of IOS include EDI ytem in a upply chain, BB electronic marketplace, and ytem for information haring in financial ervice. According to the theory of incomplete contract (Groman and Hart, 986; Hart and Moore, 990), IOS ownerhip i important ecaue it determine the value created from the IOS y affecting the participant invetment. In thi tudy, we define an IOS a a et of IT aet that upport uine relationhip. IOS Ownerhip tructure mean which participant own the IOS aet. We invetigate how IOS participant hould decide on the ownerhip tructure of their IOS to maximize the value they can capture from the IOS in variou ituation. We have argued that relative importance of participant invetment, defined a the relative magnitude of the contriution of participant incremental invetment to the IOS relationhip, i an increaingly ignificant determinant of optimal (i.e., value-maximizing) IOS ownerhip tructure (Han, Kauffman, and Nault, 004). In thi tudy, uing pecific functional form and comparative tatic, we examine the mechanim y which relative importance of participant invetment determine which IOS ownerhip tructure i optimal for the IOS relationhip. We alo invetigate the role of pecificity of IOS invetment, a lo in the value of the IOS invetment outide the current relationhip, in determining optimal ownerhip tructure. We how that pecificity of IOS invetment mediate the relationhip etween relative importance of invetment and optimal ownerhip tructure. We alo how that ownerhip may have a negative impact on the owner invetment incentive when IOS invetment reduce the value that the participant can receive outide the current relationhip. Further, we analyze a cae where poitive externalitie (i.e., complementaritie) exit etween participant invetment. THEORETICAL BACKGROUND Ownerhip of an aet i important ecaue it i impoile to pecify every poile future circumtance in a contract (Williamon, 985). According to the theory of incomplete contract, aet ownerhip implie the right to decide what to do with the aet including the right to exclude other participant from uing that aet in circumtance not covered y a contract (Groman and Hart, 986; Hart and Moore, 990). Thu, the aet owner ha tronger argaining power relative to non-owner, and can capture a larger hare of the value created from the aet. Thi value affect the participant incentive for invetment. Aet ownerhip determine the value created from the aet y affecting the participant level of invetment. The theory ugget that there are four major determinant of optimal aet ownerhip tructure: the complementaritie etween aet, the eentiality of an aet to a participant, the indipenaility of a participant to an aet, and the relative importance of participant invetment. (See Tale for definition.) We define the relative importance of participant invetment a the ranking of the coalition marginal return to each participant IOS invetment. Thi definition emphaize that the participant with the greatet relative importance i the participant whoe incremental invetment can create the mot value for the coalition it elong to.
2 Tale. Determinant of Optimal Ownerhip Structure for IOS Aet DETERMINANTS Complementaritie Eentiality Indipenaility Relative Importance of Invetment DESCRIPTION Two IT aet are trictly complementary if either one of the aet cannot create value without the other. An IT aet i eential to a participant if the participant invetment cannot create any value without the aet. A participant i indipenale to an IT aet if the without the participant in the coalition the coalition invetment cannot create any value without the aet. The relative magnitude of the value to the coalition created y participant incremental invetment. Prior work in Economic and IS focued on complementaritie, eentiality, and indipenaility (e.g., Hart and Moore, 990; Brynjolfon, 994; Bako and Nault, 997). The increaing tandardization of IT ha made thee three determinant le ignificant, however, while making relative importance of participant invetment an increaingly critical determinant of optimal ownerhip tructure. In thi tudy, we focu on the role of relative importance of participant invetment in determining optimal ownerhip tructure, and aume that no participant i indipenale to the aet. We argue that the mot critical ource of relative importance i the difference in the participant pecific knowledge aout how to create value for the coalition an information aet that i not tranferale (Jenen and Meckling, 99; Brynjolfon, 994). When one participant poee greater or more important pecific knowledge aout how to create value for the coalition, it i optimal to give that participant ownerhip of the coalition aet. ILLUSTRATION: VENDOR-MANAGED INVENTORY (VMI) We ue VMI in upply chain management to how how relative importance of invetment impact optimal ownerhip tructure. VMI i one of the mot widely-adopted upply chain initiative for improving efficiency etween a upplier (manufacturer) and uyer (retailer or ditriutor). In VMI, the upplier i reponile for managing the uyer inventory, and make inventory replenihment deciion for the uyer aed on demand and inventory information ent y the uyer. The VMI ytem aet conit of network technologie and EDI for communication and data haring, forecating oftware for market demand forecating and placing order aed on ale and inventory data, and point-of-ale and retail inventory ytem for gathering ale and inventory data. Both participant mut invet in implementation activitie, including integrating thee new ytem with their exiting internal ytem, uch a their enterprie reource planning and inventory management ytem. A MODEL FOR INVESTMENTS AND OWNERSHIP IN VMI We ue an incomplete contracting model for two-peron argaining. Drawing upon Bako and Brynjolfon (993) and Bako and Nault (997), we employ pecific functional form to analyze the impact of relative importance and pecificity of IOS invetment on the participant equilirium invetment and optimal ownerhip tructure. The uyer () make invetment x, and the upplier () make invetment x. Thee are invetment in implementation activitie uch a data ynchronization and proce redeign, and thee invetment are non-contractile. When the uyer and the upplier remain in the IOS, they can jointly create value V(x, x ) for the relationhip from their VMI ytem (e.g., reduced inventory level and increaed ale). The uyer and the upplier incur cot c (x ) and c (x ) for their invetment. Thee cot are increaing at an increaing rate in IOS invetment. We denote the value generated y the uyer and upplier In the preence of an indipenale participant, it i alway optimal for the participant to own the aet regardle of the relative importance. We will aume c ( x ) = c( x ) = x, i {, } for all three of the cae that we will hortly lay out. i i i i
3 invetment outide the relationhip a r (x a) and r (x a), where a repreent whether the correponding participant (the uyer and the upplier repectively) own the VMI aet (a = ) or not (a = 0). Thi mean that if a participant doe not own the VMI aet, then it cannot create any value outide the relationhip. V, r, and r all are increaing at a decreaing rate in IOS invetment. We refer to r, and r, the value outide the relationhip, a the diagreement payoff. They repreent the value participant receive when agreement cannot e reached in argaining. Becaue a complete contract for value haring cannot e written, the upplier and uyer divide the value through argaining. A in Clemon and Kleindorfer (99), we ue the Nah argaining olution for urplu ditriution etween the IOS participant. The two participant engaged in argaining divide the incremental profit evenly o each receive half of the incremental profit, a follow: Buyer Payoff: r( x) + [ V( x, x) r( x) r( x)] c( x) Supplier Payoff: r ( x) + [ V( x, x) r( x) r( x)] c( x) We conider two ownerhip tructure for VMI aet: upplier ownerhip and uyer ownerhip. We do not analyze joint ownerhip ecaue the payoff to joint ownerhip are lower than thee two alternative. A a enchmark, we analyze the firt-et cae where an integrated firm own the aet. We firt analyze a cae without invetment externalitie, and then perform analyi on a cae in the preence of externalitie. In the firt two cae, we aume that IOS invetment increae not only the value of the aet within the relationhip ut alo that outide the relationhip. In the third cae, we analyze a cae where IOS invetment may reduce the value of diagreement payoff to get additional inight. In each cae, we firt calculate the participant equilirium level of invetment (for integrated firm ownerhip, upplier ownerhip, and uyer ownerhip). 3 Then, we determine which ownerhip tructure i optimal y comparing the equilirium invetment level under variou condition. The ownerhip tructure that entail the greatet invetment for oth participant i optimal. We ummarize our main reult in the Dicuion and Concluion ection intead of preenting the detailed reult in each cae. Cae : No Invetment Externalitie Here, in contrat to Hart and Moore model, we aume there are no poitive or negative externalitie ariing from participant invetment. We ue the following functional form 4 : α β V( x, x) = ωx + ( ω) x, 0 α, β, ω. r( x) a ( ) x α β = ω θ and r( x) = a( ω)( θ) x, a {0,},0 θ, θ. We defined the relative importance of invetment a whoe incremental invetment make a greater contriution to the value of the overall relationhip. 5 We can ee that relative importance i determined y two factor: ω and the relative magnitude of α and β. ω repreent the contriution of the uyer invetment to the total value relative to the upplier invetment. α and β repreent how productive (or efficient) each participant invetment i. They can e interpreted a each participant capaility, expertie or knowledge to create value from their invetment. α and β can e conidered to e return to cale parameter in invetment. 3 Becaue the Heian matrice of the payoff function are ymmetric and negative definite, we can take the firt derivative of the payoff function with repect to the invetment to calculate equilirium invetment level. 4 The functional form for V i imilar to the one ued y Bako and Brynjolfon (993). It i characterized y declining marginal return of invetment and the parameter ω that characterize the relative contriution of uyer invetment. In the functional form for r and r, the pecificity of invetment i modeled a a lo in invetment value: the value of participant i IOS invetment i reduced y θ i when the IOS i ued outide the relationhip (e.g., due to cutomization and pecialization of technologie). 5 Formally, relative importance of invetment can e repreented a V α V β = ωα x, ( ) = ω β x. x x 3
4 Cae : Poitive Invetment Externalitie Here, we add an aumption that there exit poitive externalitie etween invetment y different participant. Thi mean the uyer and the upplier invetment are complementary, enriching each other. Following Bako and Nault (997), we incorporate poitive externalitie a the product of the two participant invetment in the V function a follow: α β α β V( x, x) = ωx + ( ω ) x + µ x x, 0 α, β, ω, µ, where µ repreent the ize of the poitive externalitie etween the two participant IOS invetment. Cae 3: Negative Impact of Invetment on the Value of Diagreement Payoff Now, we aume that participant invetment may reduce the value of IOS invetment outide the relationhip the diagreement payoff. To focu on the impact of diagreement payoff, we aume there are no invetment externalitie a in Cae. So, we ue the following functional form: α θ β θ r ( x ) = aωx, r ( x ) = a( ω) x 0 α, β, θ, θ. To permit comparion to e made, we analyze two u-cae: α < θ, β < θ (i.e., r ( x ) < 0) and α > θ, β > θ (i.e., r i ( xi) > 0). In the former, oth the uyer and the upplier invetment in the VMI aet reduce the value of the aet outide the relationhip, wherea in the latter, their invetment increae the value. We found Hart and Moore reult (i.e., poitive impact of ownerhip on the owner invetment incentive) doe not hold in the former although we get the reult that are conitent with Hart and Moore in the latter. DISCUSSION AND CONCLUSIONS Our analyi of the three cae how how relative importance, pecificity, and externalitie in IOS invetment affect equilirium invetment and optimal ownerhip tructure. Firt, ome of our reult are conitent with the prior incomplete contracting literature: IOS participant underinvet relative to the firt-et (an integrated firm) level in all three cae. Thi i ecaue each participant cannot capture full marginal return from it invetment. A participant invetment i greater () when the relative contriution or weight of it invetment to the total value i greater (greater ω for the uyer and maller ω for the upplier); () when it invetment i more efficient (greater α and β); 3) when it invetment i le pecific (maller θ and θ ); and 4) when the poitive invetment externalitie are tronger (greater µ). 6 Second, we found intereting interrelationhip etween relative importance, pecificity, and externalitie in IOS invetment. We howed that a participant IOS invetment increae in the relative importance of it invetment. However, our analyi reveal that the relationhip etween relative importance and optimal ownerhip tructure i mediated y the pecificity of participant invetment: When oth participant invetment are totally pecific to the relationhip (θ = θ = ) it doe not matter who the owner i, regardle of the relative importance of their invetment. When one participant invetment i totally pecific and the other invetment i non-pecific (e.g., θ =, θ = 0) it i optimal for the participant with non-pecific invetment (e.g., the uyer) to own the IOS (regardle of the relative importance of their invetment). 7 Thee reult imply that pecificity of invetment may e a more important determinant of optimal ownerhip tructure than relative importance of invetment. In the context of VMI, pecificity of invetment can e interpreted in term of how many alternative trading partner (i.e., outide option) the i i 6 Formally, x x x x x x x x < 0, > 0, > 0, > 0, < 0, < 0, > 0, > 0. ω ω β α θ θ µ µ 7 If oth participant invetment are partially pecific (0< θ, θ <), there i no clear dominance relationhip etween the two ownerhip tructure, o we need to compare the total urplu. 4
5 uyer and the upplier have with whom they can reue the VMI aet. If the uyer (e.g., WalMart) ha a large numer of upplier with whom it can reue the VMI ytem aet (e.g., y forcing them to comply with it), it pecificity of invetment i low. In contrat, the upplier invetment i highly pecific if the upplier doe not have many trading partner or if every uyer ha different ytem pecification and requirement that the upplier need to comply with. Our model ugget that it i optimal for the uyer to own the VMI aet in uch a cae. Third and mot important, Hart and Moore (990) ugget that a participant invetment alway increae when it i the owner compared with when it i not. However, we how thi may not e the cae under at leat two condition: When oth participant invetment are non-pecific and poitive externalitie are very trong (Cae ), it i poile that the allocation of aet ownerhip to the participant with the mot important invetment can increae invetment of all the participant (including thoe of nonowner). Due to the trong poitive externalitie, not only the owner ut alo the non-owner invetment increae. Thi can happen ecaue the decreae in invetment y the participant that doe not own aet i offet y the increae in invetment due to the poitive externalitie. Thi ugget that in the preence of trong invetment externalitie, relative importance ecome even more critical. When participant invetment reduce the value of their diagreement payoff (i.e., the value they can get outide the current uine relationhip) (Cae 3), IOS ownerhip reduce their invetment incentive. Therefore, it i optimal to give ownerhip to the participant with the leat important invetment; doing o will mitigate the negative impact of aet ownerhip on invetment incentive. In our VMI example, the value of diagreement payoff will decreae when the uyer and the upplier make irreverile or cotly-to-undo invetment in their VMI ytem (e.g., ytem integration and dataae chema change). Our model ugget that participant hould e careful when they make thee invetment deciion ecaue they will loe opportunitie for alternative ue of the VMI aet. Thi reduce their invetment incentive and the total value from the aet. If the uyer and the upplier have to make thoe invetment, the participant whoe invetment make the leat contriution to the total value hould e the owner. Thi will minimize the negative impact of irreverile invetment. REFERENCES Bako, J.Y. and Brynjolfon, E. (993). "From Vendor to Partner: Information Technology and Incomplete Contract in Buyer-Supplier Relationhip," J. of Org. Computing, 0(), pp Bako, J. Y. and Nault, B. R. (997). "Ownerhip and Invetment in Electronic Network," Information Sytem Reearch, 8(4), pp Brynjolfon, E. (994). "Information Aet, Technology, and Organization," Management Science, 40(), pp Clemon, E. K. and Kleindorfer, P. R. (99). "An Economic Analyi of Interorganizational Information Sytem," Deciion Support Sytem, 8(5), pp Groman, S. F. and Hart, O. (986). "The Cot and Benefit of Ownerhip: A Theory of Vertical and Lateral Integration," Journal of Political Economy, 94(4), pp Han, K., Kauffman, R.J., and Nault, B.R. Who Should Own IT? Ownerhip and Incomplete Contract in Interorganizational Sytem, Working Paper, MIS Reearch Center, U. Minneota, 004. Hart, O. and Moore, J. (990). "Property Right and the Nature of the Firm," Journal of Political Economy, 98(6), pp Jenen, M. and Meckling, W. (99). "Knowledge, Control and Organizational Structure: Part I and II," in L. Werin and H. Hijkander (Ed.), Contract Economic, Camridge: Bail Blackwell. Williamon, O. E. (985). The Economic Intitution of Capitalim. New York: Free Pre. 5
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