Fiat Without Authority Under Vertical Integration
Abstract: Relational contracts allow to enforce actions the parties would not undertake in an arm’s length transaction. In an agency context, relational contracts will thus produce fiat — a principal’s ability to dictate her agent’s performance. This paper shows that, as the agent’s task becomes more critical, vertical integration increases the principal’s (informal) power of fiat, by reducing the agent’s reneging temptation. The paper also shows that vertical integration increases the principal’s (informal) power of fiat when the parties are in a closer relationship, suggesting that integration and relational contracts are complements. An implication of the model is that, while the level of fiat observed under separation is smaller than under integration, it is still greater than what would be feasible if integration governed the corresponding relation. This sheds new light on the classic tenet that fiat is an organizational advantage of firms over markets, suggesting it may be the result of selection bias.