Market structure and integration in the Norwegian oil industry

OMEGA Int. J. ofMgmt Sci., Vol.21, No. 2, pp. 199--203,1993

0305-0483/93$6.00+ 0.00 Copyright© 1993PergamonPressLtd

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Market Structure and Integration in the Norwegian Oil Industry R DAHLSTROM A NYGAARD The Norwegian Institute for Research in Marketing, Norway (Received November 1989; in revised form June 1992) This study utilizes transaction cost economics to assess changes in the level of vertical integration in distribution channels. Utilizing time series data from the Norwegian oil industry, the authors find that small numbers bargaining and frequency are associated with higher levels of integration.

Key words--marketing, integration, oil industry, retailing

INTRODUCTION

EMPIRICAL MODEL

PERFECT COMPETITION is manifest in markets which exhibit numerous trading partners, homogeneous outputs, mobile resources and perfect market knowledge. Under these constraints the invisible hand of the market serves as the basis for determining equitable contracts [5]. When these conditions are violated firms must act to secure appropriate returns from investments. In particular, firms operating in uncertain markets with few trading partners incur asymmetries in information. These asymmetries make it difficult to determine whether profits are allocated equitably, thus jeopardizing return on investments. Organizations confronted with these conditions must coordinate activities with channel partners. Integrated distribution systems, franchized business operations and other alliances enable firms to gain access to information so that appropriate returns can be secured. The purpose of this analysis is to investigate whether uncertainty, trading partner concentration and frequency affect the degree of integration in distribution channels. We utilize transaction cost economics (TCE) to assess relationships between principles and retailers in the Norwegian oil industry.

The pursuit of efficiency is paramount to organizational economics [4, 11]. Transaction cost economics (TCE) adopts a micro-analytic orientation to efficiency in which the transaction is the focal level of analysis. A transaction is defined as the "transference of a good or service across any technologically separable interface" [26, p. 552]. TCE posits that the main purpose of economic institutions (e.g. firms, hybrids or markets) is to economize on the costs associated with transactions [27]. In order to limit transaction costs, firms take stock of the conditions under which exchange takes place. Where assets are deployed which have limited utility outside their intended application, firms assess the impact of uncertainty and frequency upon alternative contractual arrangements. Uncertainty

The ability to predict environmental conditions e x ante is critical to principals when designing contracts with agents. Unstable environments, however, make principal-agent contracts incomplete and e x p o s t realignment of the contracts costly. Moreover, uncertainty fosters asymmetry in the dissemination of 199

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information between parties to an exchange. Environmental uncertainty refers to the degree to which future states of the world cannot be anticipated and accurately predicted [19, p. 67]. When contractual arrangements drift out of alignment because of external circumstances (e.g. market turbulence), the agent can take advantage of the bilateral agreement. For instance, fluctuations or structural changes in downstream markets make it difficult to assess fair transfer prices. This marketplace volatility is a serious threat to the principal company because downstream information is often distributed asymmetrically in favour of the agent. Under fluctuating downstream market conditions agents gain an informational advantage which is difficult and costly for the principal company to evaluate. Uncertainty in downstream markets increases transaction costs and motivates the principal company to increase its ownership share in distribution. Therefore the following is proposed: H 1: increases in environmental uncertainty lead to higher levels of integration. Number of channel outlets The effect of uncertainty upon transaction costs is exacerbated by the number of trading partners. When many alternatives are available a principal may negotiate with several agents. Under these conditions market forces preclude agents from concealing information. Moreover, principals gain knowledge of environmental factors from multiple sources. As a consequence, the principal does not need to employ governance mechanisms to reduce uncertainties. In contrast, when a relatively small number of economic agents are participating the validity of information plays an important role. In channels characterized by market concentration agents appropriate quasi-rents because of limited access to alternative sources of demand [14]. Moreover, agents with few competitors often have superior access to information [17], and they gain little by sharing it with principals. Valid information is present, yet it is not ex ante equally distributed between the principal companies and the agent [3]. These asymmetries in access to valid information make it difficult and expensive to agree on a fair transfer price. System coordination becomes complicated and inefficient.

Although 'small number' bargaining produces transaction costs, the small numbers proposition has not been explored empirically in a distribution context. The small number hypothesis has been analysed in cross sectional studies of manufacturing systems [15, 16], but these analyses do not capture the idiosyncrasies of principal-agent relationships in distribution. While several studies have analysed the effect of oligopolistic market constraints upon organizations, they have not emphasized integration as a response to market concentration [6-8]. Integration of the agents makes opportunistic behaviour less attractive and facilitates the flow of information into the firm [24, 25]. Therefore, the following is proposed: H2: decreases in the number of channel outlets leads to increases in the level of integration. Frequency

According to TCE, frequent transactions which involve specific assets favour integration of agents. When companies apply specialized governance structures the set-up costs cannot be justified for occasional or few transactions. Therefore, a low level of frequency does not motivate integration even when specific assets are present [27]. Independent channels have been associated with low transactional frequency in the construction [10], forestry [12] and biotechnology industries [20]. In contrast, high volumes of transactions make investments in specialized governance systems efficient for the principal company. Therefore the following is proposed: H3" increased frequency of transactions between principals and agents leads to a higher degree of integration. DATA ANALYSIS

The empirical setting is six major oil companies and their dealers--together these channels represent over 98% of the gasoline market in Norway. In 1990, 2370 gasoline stations represented the oil companies in the market. The petroleum distribution industry is an excellent setting for transaction cost analysis since principal companies invest heavily in trademarkspecific assets [28] which have marginal value outside the principal-agent relation [13, 22].

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Table 1. Summary of operationalizations Expected sign

Operational definition

Variable

Percentage of units owned by oil companies Standard deviation based on monthly gasoline prices throughout each year Total number of outlets in the market Volume of gasoline (in 1000 ms) distributed by dealers in the Norwegian market

VI UNC AG FREQ

The gasoline market is characterized by homogeneous products. Homogeneous products make it possible to explore the small number bargaining problem. In addition, the empirical setting does not violate the validity of time series by product differentiation or heterogeneity. The Norwegian market is characterized as a stable social, economic and political empirical context that is not influenced by severe third variables during the time period studied [1]. The empirical analysis was conducted by using company level data, industry level data and market price information. We estimated the following model: VI = fll U N C + fl2AG + fl3FREQ + e.

Table 1 provides an overview of the operational definitions in the empirical model. The model contains annual data from 1973 to 1990. The vertical integration variable (VI) is operationalized as the percentage of company-owned gasoline stations in the market. Uncertainty (UNC) was estimated from monthly gasoline prices. The gasoline price index for each month was estimated as follows: GPI(m.y) = 100\I \ s u ( f

= 1,6,a
where GPI(,,,y) = the gasoline price index in m o n t h m and year y at1~,,y) = the market share of f i r m f d u r i n g m o n t h m of year y P~y.m,y)= the price of gasoline for firm f during m o n t h m of year y Pt0~ = the m e a n price of gasoline in the basis year, 1973.

To construct a measure of uncertainty we applied the following standard deviation formula: UNC(y) = \ R ( ( \ F ( I , 1 2 ) ) \ I \su(m = 1,12,

× (GPI¢,,.y) - GPIty))2 ))

Mean 58.01 3.70

+ +

2774 2295

Standard deviation

Minimum

2.34 3.30 375.1 440.6

53.8 0.83 2370 1566

Maximum 62.7 13.93 3561 2916

where UNC(y) = uncertainty in year y GPIty) = mean uncertainty in year y.

AG is employed to describe the level of market concentration in the principal-agent context. The buyer side concentration measure (AG) is the number of gas stations in Norway operating during the 18 year period. The frequency variable (FREQ) is the volume of gasoline distributed by the gasoline stations. VI, AG and FREQ were gathered from the Norwegian Petroleum Institute while UNC was constructed from monthly price data supplied by the Norwegian Central Bureau of Statistics. M o d e l estimation and results

The hypotheses were tested by applying ordinary least square regression. Table 2 provides the correlations among the dependent and independent variables. The high correlation between AG and FREQ had the potential to undermine the regression, but univariate regressions indicated that multicollinearity was not problematic. The Durbin-Watson procedure is used to test whether the error terms in a time series are correlated [9]. The Durbin-Watson test produced a value of 0.96 which indicated autocorrelation among the errors. We corrected for autocorrelation through the iterative technique outlined by Neter et al. [18]. Through iteration, the independent and dependent variables are transformed to control for lag effects. After a single iteration the test statistic (D = 1.46) indicated that autocorrelation was no longer problematic. Table 2. Correlation matrix of dependent and independent variables 1. 2. 3. 4.

VI UNC AG FREQ

1.00 0.52 -0.88 0.85

1.00 -0.35 0.34

1.00 -0.87

1.00

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Table 3. Ordinary least squares regression analysis of ante~dents to ownership conversions (n = 17)

Independent variables

Beta coefficients

HI--UNC H2--AG H3----FREQ Adjusted R 2 Overall F D u r b i n - W a t s o n test

0.241 - 1.164 b 0.728 ~ 0.81 23.81 b 1.46

' P < 0.05; bo.oI.

Table 3 presents the standardized 8coefficients of the regression equation of the empirical model. The model fits the data well (F = 23.81, P < 0.001; Adj. R 2 = 0.81). Only directional support is provided for the hypothesis that uncertainty affects the level of integration (81=0.241, P<0.34). The data strongly support the hypothesis that fewer buyers (dealers) affect the level of integration (82 = - 1.164, P < 0.01). Similarly, the frequency (FREQ) of transactions between the principal companies and the dealers significantly affects the level of vertical integration within the industry (83=0.728, P < 0.05). Thus, H2 and H3 are supported, but H1 is not. DISCUSSION Vertical integration decisions are difficult to reverse, and it is critical to assess the processes by which channels evolve [21]. TCE is a normative framework that addresses e x a n t e coordination and has rarely been utilized to assess changes in the degree of integration. Our study illustrates how the rationale from TCE may be used to account for ownership modifications in retail outlets, TCE maintains that uncertainty makes market-based exchange less efficacious. The 18 year period in our study was marked by considerable variance in retail oil prices, yet these fluctuations did not appear to affect the level of integration. Although integration may provide greater access to downstream market conditions, such information may not be useful in determining retail oil prices. To the extent that pricing is perceived to be a function of factors extraneous to consumer preferences (e.g. drilling and refining expenditures), downstream integration may not be regarded as a means for reducing uncertainty and securing efficient transactions.

To our knowledge, the small numbers hypothesis [23] has only been tested twice before, but not in a principal-agent context. The time series applied here offers temporal asymmetry that makes it possible to analyse the structure of the transaction cost argument. Our results strongly support the prediction from the transaction cost perspective that fewer buyers in the market affect the level of forward integration. Integration-based control systems serve to streamline the flow of information into the firm. As a consequence the information impactedness associated with small numbers bargaining is reduced. Principals and agents in integrated systems share objectives thus making self-interest seeking less desirable. In addition, reporting and control mechanisms make opportunism more difficult to exercise in integrated channels. Consistent with TCE, frequent transactions involving trademark specific assets provide incentives to internalize transactions. Investment in governance structures appear to be justified for recurring transactions since higher volumes of distribution lead to higher levels of integration among oil retailers. The purpose of this analysis was to assess the effect of transaction cost dimensions upon vertical integration in the Norwegian oil industry. While our study provides some support for TCE, future analyses should augment this analysis with other operationalizations of transaction-cost elements. Uncertainty, for example, may be manifest in behavioural opportunism [13], technological constraint [22] and environmental contingency [2]. Each of these factors may have a discriminating impact upon the level of integration. Although our secondary data provide seemingly objective measures of TCE elements, decisions may be based upon perceptions of these factors. Thus, secondary reports should be complemented with studies that address perceptions of small numbers bargaining, frequency and uncertainty in the environment. Finally, progress in science often occurs through incremental contributions derived from applications of theory in a variety of contexts. Empirical analyses have the potential to support or refute the tenets of a theory. It is hoped that our study contributes to the understanding of interorganizational alliances and stimulates further research in the transaction cost paradigm.

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