In-house and Arm's Length: Productivity Heterogeneity and Variation in Organizational Form.

Stephen F. Lin (Federal Reserve Board)
Catherine Thomas (London School of Economics)
Arturs Kalnins (University of Iowa)

Abstract: This paper studies variation in firm boundaries in the US hotel industry. For most hotel brands, the properties with the lowest and highest room occupancy rates are managed at arm's length by franchisees---a form of outsourcing. Properties with intermediate levels of occupancy tend to be managed by company employees, meaning that hotel management is vertically integrated. We propose a model of organizational form choice that can explain these patterns as the result of trade offs between relative fixed costs, control right assignment, and the option to include state-contingent performance incentives in contracts. Hotel brands prefer to manage properties at intermediate levels of productivity because retaining control increases the brand's relationship-specific investment. Low occupancy properties are outsourced because of lower fixed costs. High occupancy properties are outsourced under rent sharing agreements with the franchisee that complement the franchisee's incentives to invest in the relationship arising from control rights. We show that the complementarity between these incentive mechanisms outweighs the brand's concerns about hold up for high occupancy properties in all but the highest quality brands and in all locations other than where performance incentives are costly due to high local taxes.