Bargaining power and the structure of alliance contracts B. Taub A. - PDF document

Bargaining power and the structure of alliance contracts B. Taub ∗ A. Seth † May 2, 2010 Abstract Consider an alliance between an entrepreneurial biotech company and an established pharmaceutical company. Frequently, small biotech firms require complementary assets and services from big pharmaceutical com- panies in order to develop a promising molecule to the stage whereby they can generate cash flows. At the same time, big pharmaceutical firms need the innovations developed by entrepreneurial biotech firms to build a pipeline of promising drugs. The relationship between biotech firms and pharmaceutical firms is thus characterized by complementarities. Actually realizing the potential of the complementarities can be diffi- cult. In the first place, the technological possibilities are characterized by risk. In the second place, although there are profits from collaboration, the partners also have divergent interests. Each firm has its own objec- tives: a big pharmaceutical firm has its own portfolio of projects that it is trying to optimize, and therefore may defect from a joint development agreement with the biotech firm if another promising molecule for the same end use becomes available. Similarly, the biotech firm has its own priorities. For example, it could seek to use the research efforts funded by its big pharmaceutical partner on related projects from which it derives private benefits. Accordingly, it becomes important to consider how con- tracts can be designed to achieve cooperation between the two firms. Our theory provides a recipe for these contracts. Unlike property rights models that focus only on how cooperation may be achieved in the investment stage of a project, our theory explic- itly considers the resolution of incentive problems that arise both in the investment stage and the subsequent execution stage. Thus, it provides a richer and more complete explanation of cooperative action. Our theory quantifies the ability of each firm to extract rents from a contract; we refer to this as bargaining power. We show that excessive bargaining power can prevent an alliance from forming because of the excess incentive to defect. But investment by firms can moderate this bargaining power to overcome the defection incentive and allow alliance formation. We quantify the ∗ University of Illinois. † Virginia Tech. 1

resulting contract in terms of investment, the cost of that investment, payoffs, and net profits, all of which can be asymmetrically distributed across the firms. Contents 1 Introduction 3 1.1 Formation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1.2 Bargaining power and the resolution of the formation problem . 4 2 Relationship to the literature 5 2.1 The prt approach . . . . . . . . . . . . . . . . . . . . . . . . . . 5 2.2 Limitations of the prt approach . . . . . . . . . . . . . . . . . . 5 3 The model 6 3.1 Some technical details of the model . . . . . . . . . . . . . . . . . 8 3.2 The link between investment and bargaining power . . . . . . . . 8 3.3 Mechanics of the model . . . . . . . . . . . . . . . . . . . . . . . 10 4 The impact of costs 12 4.1 The consequence of positive costs . . . . . . . . . . . . . . . . . . 13 5 A basic example of joint profit maximization 14 5.1 Stage 1: Formation . . . . . . . . . . . . . . . . . . . . . . . . . . 15 5.2 Stage 2: Optimizing costs conditional on formation . . . . . . . . 16 5.3 The effect of costs . . . . . . . . . . . . . . . . . . . . . . . . . . 18 5.4 Increasing the initial relative bargaining power of firm 1 . . . . . 18 5.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 6 A basic example of selfish profit maximization 21 6.1 Equal costs—the selfish case . . . . . . . . . . . . . . . . . . . . . 22 6.2 Increasing firm 1’s initial relative bargaining power—the selfish case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 6.3 Formation is more sensitive to cost in the selfish profit maximiza- tion case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 7 Conclusions 26 2

1 Introduction Two pirates, Captain Flint and Long John Silver, want to row to an island that lies across a strait in order to dig up a treasure chest. There are rival pirates who are trying to get there first. Flint and Silver have a boat, but it lacks oars. They must decide whether or not to make oars cooperatively, each knowing that he cannot reach the island before the rivals if he rows alone. Flint’s and Silver’s respective investments will impact the quality of the oars they make and thereby the speed with which they cross the strait, and whether they cross it at all. If they decide to build the oars, each must subsequently also decide how hard to row across the strait. Because they are pirates, they understand that the other will have incentives to shirk when rowing. Each can pretend to row hard, but the other cannot verify effort instantaneously. However, both can observe that the other has deviated from a pattern of rowing and rest. They must therefore solve two incentive problems. They may have the in- centive to underinvest in building the oars, and they may also have the incentive to shirk as they row. These incentive problems seem unconnected, but we will show that they are linked. Flint’s and Silver’s problem is analogous to that of two firms considering whether to undertake investments in relationship-specific complementary assets in a world of incomplete contracting. For example, the terms of the 1978 con- tract between Genentech and Eli Lilly for joint research on human insulin was the subject of protracted negotiation. 1 How firms solve such incentive problems is central to the theory of the firm. 1.1 Formation To show how to solve the contracting problem we create an analytical framework that incorporates the following elements: • The incentive to invest and the cost of investing during the oar construc- tion phase. • The incentive to cooperate during the rowing stage. Unlike previous formulations that focus on one or the other of these incentive problems, our framework examines the link that arises because the pirates an- ticipate how their investments will affect their incentives when they are rowing. We denote the successful resolution of the contracting problem as formation . This resolution entails two stages: the stage in which the oars are made, which we denote the investment stage, and the rowing stage, which we denote the execution stage. In the investment stage the pirates decide not only whether to make the oars but also how big to make them. These decisions will be influenced both by the costs of making oars and by incentives in the rowing stage. Unless 1 Ultimately, the world’s first biotechnology drug, Humulin, was the outcome of this alliance. With its patent expiring in 2002, Humulin is still a major drug with 2003 sales of over $1 billion—the treasure!. 3