Endogenous Altruism in Buyer-Seller Relations and its Implications for Vertical Integration

This paper considers a standard buyer-seller relation where the seller can take noncontractible actions that raise the value of the good to the buyer. This relationship can either take place inside a firm so that the buyer can give orders to the seller or across firm boundaries. Both the buyer and the seller can, if they wish, become altruistic towards one another. Becoming altruistic is costly and leads individuals to care about the other individual’s payoffs ex post. Still, its observability can lead it to arise endogenously in buyer-seller transactions. Under plausible conditions, altruism from seller to buyer arises more easily for outside contractors than for employees. The result is that endogenous altruism can be a force that leads to disintegration. Altruism from buyers to their supplying contractor can also arise. As suggested by the empirical literature, it increases the frequency of purchases. (JEL: D2, L2) ∗Harvard Business School, Soldiers Field, Boston, MA 02163. Email: [email protected]. I wish to thank George Baker, Bob Gibbons, Oliver Hart, Ramon Casadesus Masanell and Rakesh Khurana for helpful conversations. Sociologists of organizations such as Granovetter (1985) and Uzzi (1997) have emphasized that many economic transactions are “embedded” in social relations or, more particularly, are carried out between personal friends. Uzzi (1997), for example, contains vivid descriptions of friendship between executives at apparel “manufacturers” (buyers) and executives at “contractors” (the firms that actually make the garments). Friendship ties also exist within firms, though frequency of interactions at work is only loosely relate to the strength of these ties, and I am not aware of any study showing warm feelings between people engaged in transactions across the divisions of a single firm. There is, by contrast, evidence that many inter-divisional transactions occur in an atmosphere of conflict and acrimony. Eccles and White (1988) give several examples of this conflict and say that, as a result of it “Most managers interviewed in the field study expressed the view that internal transactions were more difficult and costly than external ones” (p. S40). They quote one manager as saying “The internal guy, whether as supplier or as user, is never treated as well” (p. S47) and discuss a case in the semiconductor industry where “both buyer and seller would have preferred external transactions” (p. S43). Inspired by these contrasts, this paper studies conditions under which altruism is more likely to arise between people engaged in transfer of goods and services across firms than in similar transfers between people transacting within a firm. In this formulation, altruism captures a particular element of friendship, namely the tendency to provide more help to friends than to others. In Uzzi (1997), for example, suppliers who have special relationships with their customers make extra efforts to supply high quality goods. Uzzi (1997, p. 47) describes a “special” contractor that cut a dress “to different sizes depending on the dye color used because the dye color affected the fabric’s stretching. The manufacturer who made the Uzzi (1997, p. 42) quotes a manager as saying “It is hard to see for an outsider that you become friends with these people business friends. You trust them and their work. You have an interest in what they are doing outside of business” Burt and Knez (1996) report that, when asked to name the business contact that they perceived as most selfish and untrustworthy, 3% of the managers in their sample named someone they interacted with daily. These difficulties with internal transactions are reflected in Walker and Poppo’s (1991) questionnaire study of a large buyer’s perceptions. This buyer claimed to have somewhat more difficulty reaching agreement about the allocation of engineering and cost changes when he was dealing with an internal profit center than when he was dealing with an outside supplier.