When Do Multinational Firms Outsource? Evidence From the Hotel Industry

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1 When Do Multinational Firms Outsource? Evidence From the Hotel Industry Stehen F. Lin and Catherine Thomas January, 008. Abstract Multinational rms face two questions in deciding whether or not to outsource a stage of roduction. First, where should roduction be located? Second, who should own or control the roductive assets? In this aer, we test two theories of these outsourcing decisions and we focus on the redictions for the ownershi/control decision. We adat the Antras and Helman (004) roerty rights and Grossman and Helman (004) managerial incentives models of the multinational rm to a setting in which a hotel headquarters chooses the size and organizational form of each of its hotel roerties. The roerty rights mechanism redicts a monotonic relationshi between the size of a hotel and the robability that it is owned by the headquarters. The managerial incentives mechanism redicts an inverted-u relationshi between size and the likelihood that the headquarters controls the hotel; small and large hotels are likely to be managed by a third arty, while medium-sized hotels are likely to be managed by the headquarters. We test these roositions using new data on the organizational form, location, and size of more than 4000 hotel roerties that oerate under 5 di erent brands in 03 countries. Four hotel brands exhibit atterns that are consistent with either mechanism. For three other brands, organizational structures are consistent with the redictions of the managerial incentives mechanism and inconsistent with the redictions of a model based solely on roerty rights concerns. These results suggest that agency roblems are an imortant in uence on the organizational choices of multinational rms. However, the relative imortance of agency and holdu roblems may vary substantially across brands. We are grateful to Pol Antras, Gary Chamberlain, Elhanan Helman, Bryan Lincoln, Marc Melitz, Matthew Slaughter and seminar articiants at Harvard, MIT, the 004 NBER ITO Meeting and the 007 Dartmouth/Tuck Summer Cam for helful comments. Rembrand Koning and Julia Zhou of the Paul Milstein Center for Real Estate at Columbia Business School rovided excellent research assistance. Lin bene ted from nancial suort from the Bradley Foundation and from the Harvard Economics Deartment, and Thomas bene ted from nancial suort from Harvard Business School and Columbia Business School. All errors are our own. stehen.f.lin@gmail.com, cmt@columbia.edu.

2 Introduction Multinational cororations (MNCs) lay a ivotal role in modern international trade. Rugman (988) estimates that the ve hundred largest MNCs account for over one half of global trade ows and one fth of global GDP. Accordingly, a sizeable literature in international trade analyzes the organizational choices made by MNCs and their imlications for global trade atterns. In this aer, we gauge the ability of two new theories of the multinational rm to exlain withinindustry heterogeneity in multinational cororations choices of organizational structure. Antras and Helman (004) analyze these decisions using the in uential roerty rights theory of vertical integration develoed by Grossman and Hart (986) and Hart and Moore (990). Grossman and Helman (004) analyze the multinational s organizational form decision using a rincial-agent framework, drawing on the insights of earlier work such as Holmstrom and Milgrom (99) and Horn et al. (995). Each aer models two facets of the rm s organizational design roblem. First, in which countries should its intermediate goods (or services) be roduced? Second, should it roduce these intermediate goods in-house, or should it outsource roduction to a third arty from whom it urchases goods at arms length? The two models generate contrasting redictions for the relationshi between an MNC s roductivity and its organizational choices. In this aer, we undertake (to the best of our knowledge) the rst emirical test of these two theories using data from the hotel industry. We modify the theories to examine the headquarter s choice to integrate with a downstream roducer rather than an ustream sulier of an intermediate inut as in the original models. In our model, the headquarters (HQ) chooses whether or not to integrate with its downstream roducer, weighing the same fundamental costs and bene ts as in each of the original models. In addition, the level of an investment in hysical caital, x K, is also determined endogenously. We focus exclusively on the integration decision; due to rohibitively large costs of exorting lodging services, roduction of the nal service always occurs in the local market. The modi ed theory in this aer redicts a relationshi between the relative ro tability of outsourcing and x K. The nature of this relationshi deends on the roles layed by roerty rights and managerial incentives in determining behavior at the roerty level. The e ect of roerty rights concerns leads to a monotonic relationshi between x K and the robability that the headquarters owns its downstream roducer. When the headquarters investment is more imortant, the redicted correlation is ositive; when the downstream roducer s investment is more imortant, the correlation is redicted to be negative. The resence of e ective managerial incentives generates an inverted-u shaed relationshi between x K and the likelihood that the headquarters manages its downstream roducer; nal service roducers with low and high levels of x K are likely to be managed by a third arty, while roducers with intermediate levels of x K are likely to be managed by the headquarters. We test these contrasting redictions using a new data set for the hotel industry. We constructed As reorted in Brainard (997).

3 this data set by combining rimary data that we obtained directly from two major multinational rms with secondary data that we urchased from Smith Travel Research, a hotel industry consultancy. The result is a cross-sectional data set containing roerty-level data for 44 hotel roerties that belong to 0 di erent brands and that are located in 03 countries. For each roerty, we have data on organizational form, hotel size, location and, in some cases, the dates of oening and brand a liation. We use two di erent measures of integration rst, whether or not the headquarters outsources ownershi of a roerty then second, whether or not hotel oeration is outsourced. When both ownershi and oeration are outsourced, the hotel is a franchised roerty. We use the number of rooms in each hotel as a roxy for the caital investment x K. Our main results are as follows: Four hotel brands rovide evidence that is consistent with the redictions of the model when roerty rights and/or managerial incentives determine the choice of organizational form. These brands are Hamton Inn, Holiday Inn, Hilton in the US and Marriott. Three brands, including Radisson, exhibit atterns that are consistent with the redictions of the model when managerial incentives lay a signi cant role in determining variation in organizational form. These results are largely robust to controls for otential omitted variables at various geograhical levels and to controls for hotel age. This aer relates to a relatively small emirical literature. Several aers have focused on the roerty rights model of the rm; see Joskow (987), Woodru (00), Acemoglu et al. (003), and Lerner and Merges (998). Our aroach is close in sirit to Feenstra and Hanson (004) and Baker and Hubbard (00). Feenstra and Hanson estimate a roerty rights model of international outsourcing using data on Chinese exort rocessing factories. Baker and Hubbard nd atterns of ownershi in the trucking industry that suort both the roerty rights and managerial incentives views of the rm. The structure of the aer is as follows. Section resents the model and derives the key testable imlications. Section 3 discusses the data set. Section 4 resents the estimation strategy. Section 5 contains the results and robustness checks, and Section 6 concludes. A Simle Model of Organizational Form in the Hotel Industry In order to motivate the emirical analysis in the most arsimonious fashion, we use a artial equilibrium model of organizational form, relationshi-seci c investments, and managerial incentives, for a single headquarters-roerty air. The model combines elements of the AH (004) model, the GH (004) model, and the roduction function set out in Acemoglu et al., (003). In the model, HQ chooses organizational form to maximize its own ayo given that the surlus of the roject deends on the non-contractable inuts of a local roerty level manager or entrere- We are in the rocess of gathering hotel level data on average room rice, occuancy rate, and amenity level. We will use this data to construct additional variables redicted to correlate ositively with hotel roductivity. This data will hence facilitate further tests of the relative strength of the di erent e ects in the model. 3

4 neur. We allow for two mechanisms through which decision-making at the roerty level imacts the surlus. First, the roerty must choose a relationshi seci c investment level and second, it chooses how much e ort to exert. E ort determines the robability that the roerty s investment is low or high quality. As will be described below, the distinction between the two tyes of local level inut allows us to determine whether managerial incentives in uence the actions taken by the roerty or whether roerty-level behavior is determined by roerty rights concerns that are not mitigated by the use of incentive-based contracts.. The environment There are two tyes of roducers: hotel headquarters and hotel roerties, both of which are risk neutral. Due to rohibitively high transortation costs, roduction of the nal hotel service always occurs in the local market. Before roduction begins in each market, the headquarters incurs a xed costs f E in order to enter the market. Uon aying this xed cost, the headquarters matches with a otential hotel roerty, and the headquarters-roerty air draws a total factor roductivity arameter from a known distribution F (). In order to realize any outut, the two arties must roduce three relationshi-seci c inuts: the headquarters investment x H, the local roerty s investment x L, and caital investment x K. 3 In addition, we introduce the ossibility that the e ort the roerty exerts on a variety of tasks a ects the contribution to outut of his or her own relationshi-seci c investment. As in GH, e(j) is the e ort exerted on task j. The robability that x L is high quality is determined by the e ort exerted on these tasks. The robability that x L is high quality is given by R [e (j)] dj. The robability that x L is low quality is then R 0 [e (j)] dj. We diverge from the GH model by secifying that the e ort exerted on each task is one of three ossible levels: 0, e, or E. Each of these e ort levels, if exerted on all tasks, induces high quality x L with a discrete robability. We assume that, if e ort level e = 0 is exerted on all tasks the robability of high quality x L is equal to (0) = 0. Similarly, (e ) = and (E) = E. We imose assumtions on the relationshis between the robability levels and the e ort levels which are equivalent to requiring diminishing marginal returns to e ort, and which arallel the assumtion in GH that () is concave. 4 Similar in form to the roduction function in Acemoglu et al., (003), the nal service is a function of roductivity, the three relationshi-seci c investments, and the robability that the roerty s relationshi-seci c investment is high quality, (): 0 F (x H ; x L ; x K ; ; ()) = (hx H + lx L () + x K ) I () where h and l measure the imortance of the headquarters and local investments relative to 3 x H could reresent investment by the HQ in the relationshi-seci c human caital of the oerator of the roerty - for examle, teaching the oerator all of the comany s olicies and rocedures. x L could reresent comlementary investments by the oerator in his/her own relationshi-seci c human caital - for examle, learning how to use the comany s IT systems. 4 We require that 0 > 0, so that 0 x L > 0. Even if x L is low quality with a high robability, ositive outut will be realized as long as x H, x K and x L are all ositive. 4

5 the caital investment, and I is an indicator variable that takes on the value of if x H > 0, x L () > 0, and x K > 0. This indicator variable encomasses two assumtions that simlify the analysis dramatically. First, each inut is comletely tailored to the relationshi and is therefore worthless outside the relationshi. Second, the inuts are comlementary only in the sense that a ositive amount of each one must be rovided in order to realize any outut. Once this condition is met, there are no further roduction comlementarities. We also follow Acemoglu et al., (003) in assuming that each of the three investments generates quadratic disutility costs: H (x H ) = (x H) L (x L ) = (x L) K (x K ) = (x K) In addition, the roerty incurs costs associated with the e ort it exerts. The cost of e ort on task j is e(j), and the total cost of e ort is R e(j)dj. Marginal costs to e ort on a single task j are 0 constant and all tasks contribute equally to the robability that x L is high quality. Only HQ has the technology to roduce x H and x K. Only a hotel roerty has the know-how to roduce x L, and the ability to exert e ort to increase the robability that x L is high quality. As is standard in the literature, we assume that x H, x L, and e ort are not veri able by a third arty, but we assume x K is veri able and the quality of x L is observable ex ost. Since this investment corresonds to the construction of a hysical asset that can be observed easily, it is not subject to the hold u roblem that a icts the other two relationshi-seci c investments. Before investment, e ort, and roduction occur, an organizational form is chosen. The organizational form can be either vertical integration of the hotel roerty into the HQ rm, or outsourcing, in which the two remain indeendent. The HQ chooses the size of the caital investment, x K, and o ers to the hotel roerty an organizational form and a scheme of ex ante transfer ayments. The hotel roerty decides whether or not to accet the o er.. Organizational form The choice of organizational form has three imortant consequences. From the oint of view of the HQ, the rst two consequences favor vertical integration and the third favors outsourcing. First, the organizational form chosen a ects the outside value, and hence the investment incentives, of each arty as in the AH model. Under outsourcing, failure to reach agreement on the division of revenues leaves both arties with zero income from the bargaining game (above the value of x K, which can be recovered by HQ), since x H and x L are seci c to the relationshi. Under vertical integration, however, HQ has more ower. In this case, if negotiations break down, HQ can re the oerator of the roerty, recover x L and realize a fraction of the outut of the nal service in addition to the full value of the caital. The oerator of the hotel roerty receives no 5

6 income from the bargaining game in this case. Using OVi k to denote arty i s outside value under organizational form k (where k = I corresonds to vertical integration and k = O corresonds to outsourcing), we have: OV O L = OV I L = 0, and OV O H = x K, OV I H = x K + (hx H + lx L ()). Second, the organizational form determines whether HQ can monitor directly the e ort level exerted by the roerty as in the GH model. Under outsourcing, HQ cannot monitor, or contract on, the e ort level exerted on any of the required tasks that go into x L. Under vertical integration, HQ can directly observe the manager s e ort exerted on a fraction of all tasks. It can hence contract on the e ort level to be exerted on these tasks, meaning that the otimal level of e ort can be induced on a fraction of tasks without having to ay the manager rents. Third, organizational costs deend on organizational form (but not the scale of roduction), again as in the AH model. Outsourcing in any market entails a xed cost for HQ of f O. The xed cost to HQ of vertical integration is roerty-seci c, stochastic, and denoted by f I. We assume that in each market, f I is drawn from a known distribution H(f I ), and E(f I ) > f O ; on average, vertical integration entails higher management and negotiation costs..3 Utility and bargaining game ayo s The headquarters utility under organizational form, k is: U k H = y k H xk H xk K f E f k + T k b k () k () where yh k is the HQ ayo from the Nash bargaining game, as a function of its outside value and the quasi rents (s k ) de ned below. T k denotes the ex ante transfer ayments to the HQ from the third arty stiulated in the contract (decided before x L and e k are chosen by the roerty), and b k is the bonus ayment required only in the event that x L is high quality. Similarly, the utility of the hotel roerty under organizational form k is: U k L = y k L xk L T k + b k () k e k (3) where e k is the cost of e ort. We model the bargaining rocess as a symmetrical Nash bargaining game, from which each arty obtains its outside value lus one-half of the quasi-rents. Once the investments are sunk, the quasi rents are equal to outut less the two arties outside otions: s k = F OV k H OV k L = (hx H + lx L () + x K ) OV k H since OVL k is equal to zero in both organizational forms, and where the last equation holds if I =, that is, all investments are ositive. Note that the two arties bargain over the quasi-rents ex ost under both organizational forms, thus arty i s ayo from the Nash bargaining game can 6

7 be written as: y k i = sk + OV k i.4 Equilibrium Following AH, we assume that the suly of oerators of hotel roerties is in nitely elastic, and that each otential oerator of the hotel roerty has an outside otion equal to zero. We also assume there are caital constraints on otential entrereneurs which limit the size of the transfer HQ can extract from an entrereneur Outsourcing equilibrium investment levels Headquarters chooses x H and x K and the roerty chooses x L and a level of e ort, e. The model is solved in Aendix A to show the choice of relationshi-seci c investments and caital investment. These are: x H = h x K = x L = l () The hotel headquarters chooses how to structure the details of the outsourcing contract to address the issue that e ort is unobservable. The contract seci es the ufront fee to be aid by the entrereneur to HQ, T O (u to the caital constraint s c ) and a bonus ayment b O to be aid to the entrereneur ex ost only in the event that the roerty level investment is observed to be high quality. The HQ chooses T O and b O so as to maximize its own utility given that it can redict how the entrereneur will resond to the terms of the contract, and subject to the articiation and caital constraints on the entrereneur. One comlication faced by HQ is that e ort, e k, and the level of the relationshi-seci c investment, x L, will deend on the contract terms. The discrete nature of e k and the robability function () allows us to secify the ayo s to HQ under each ossible e ort level, where HQ structures the contract to ensure the maximum ossible ayo to HQ given the e ort level exerted. When the caital constraint does not bind for each ossible e ort level, then HQ can rovide incentives for the entrereneur to exert the e cient level of e ort through the bonus ayment b O. HQ can then cature all of the rents through the ufront fee T O. However, when the caital constraint does bind, then HQ must either accet subotimal e ort levels or share rents with the entrereneur. The ayo s to HQ from contracts that secify each of the three investment levels are derived in Aendix A. 5 In the absence of a caital constraint, the HQ can let the agent cature all revenues in the event of success (thereby inducing the e cient level of e ort on all tasks) and extract all the surlus from the relationshi via the contracted transfer, e ectively selling the roject to the entrereneur. In this case, outsourcing will always dominate VI (if roerty bears c?), from the ersective of the MI model, not the PR in uence on org form. 7

8 .4. Vertical Integration equilibrium investment levels The utility functions for each arty under vertical integration re ect the fact that HQ can monitor directly, and contract uon, the e ort level exerted by the roerty on a fraction of the required tasks. We denote m as the contribution to the robability that local investment is high quality made by the fraction of monitorable tasks, e m. n denotes the the equivalent for the fraction ( ) of non-monitorable tasks, e n. In addition, there is no ufront transfer T I from the roerty to HQ, to cature the intuition that HQ cannot secify a negative wage for the roerty manager. The contract sets out the required e ort level, and a bonus ayment, b I, to be aid if the roerty level investment is high quality. As outlined above, the surlus generated, s I, re ects the fact that HQ s outside value is non-zero under VI. The model is solved in Aendix B to show the choice of relationshi-seci c investments and caital investment. These are: x H = ( + ) h x K = x L = ( ) (l m + l ( ) n ) Holding () = m = n constant, this elementary model delivers the standard result from the roerty rights view of the rm. Namely, allocating residual rights of control to the HQ strengthens the investment incentives of the HQ at the exense of the investment incentives facing the hotel roerty. By comaring equilibrium investment levels under the two ownershi structures, one can easily see this e ect of vertical integration. In articular, x I H > xo H and xi L < xo L for any > 0. Vertical integration increases the value of the HQ s outside otion, and hence its share of surlus; it has the oosite e ect on the hotel roerty. As a result, it stimulates more investment by the HQ while it deresses investment by the hotel roerty, relative to outsourcing. The strength of this e ect increases with ; the more outut HQ can realize in the event of a breakdown of the relationshi, the stronger its investment incentives (and the weaker are those of the hotel roerty). In the limit as aroaches, x H aroaches the socially e cient level (h) and x L aroaches 0. Note that x K = under either organizational form. Finally, for (0; ) note that as was the case for outsourcing, x I L, xi H, and xi K are all increasing in, since the marginal return from each of the three investments in increasing in total factor roductivity. We now turn to discuss how this standard roerty rights model result interacts with the e ect of the discrete robability distribution (), the e ort exerted by the roerty. We have allowed the hotel headquarters to structure the details of the management contract to address the issue that the e ort made by the emloyed manager, as well as the choice of x L, is imerfectly observable. However, in contrast to the choice of x L, we allow HQ to o er an incentive system to ensure the otimal e ort is exerted. The contract seci es a bonus ayment b k to be aid to the manager only in the event that x L is high quality. As noted above, the level of the relationshi-seci c investment, x L, will deend on the contract terms through the e ort levels. Since there are three ossible e ort levels for each task, and the manager can choose to exert 8

9 a di erent amount of e ort on the grous of non-monitored tasks to that which he is contracted to exert on monitored tasks, there are nine ossible combinations of overall e ort level that can be exerted. In each case, the bonus ayment must ensure that the manager s exected ayo satis es his articiation and the equilibrium e ort levels satisfy his incentive comatibility constraints. The ayo s to HQ in each of the nine ossible scenarios are derived in Aendix B..5 Choice of Organizational Form as a function of For any draw, the HQ chooses the organizational form that yields the highest ayo, U H, when comaring the maximum ayo ossible under outsourcing and under vertical integration. The relative ro tability of vertical integration as a function of deends on the roles of x L and roerty level e ort. To illustrate the di erent mechanisms in the model, we rst limit the role layed by managerial incentives. This either means that there is no bonus scheme or, equivalently, that the e ort exerted by the roerty has very little imact on the robability that x L is high quality and incurs no cost to the agent. At each level of, we can comare the maximum ayo to HQ under outsourcing to the maximum ayo from vertical integration. When there is no bonus and the robability that x L is high quality is xed, HQ s ayo to outsourcing when caital constrained from any of the three scenarios is: U H = 8 h + 4 l + f E f O + s c Where is the xed robability that x L is high quality in the absence of managerial incentives. Under vertical integration, with no managerial incentives mechanism, all scenarios yield the same ayo to HQ of: U H = 8 h ( + ) + 4 l ( + ) ( ) + f E f I These two equations show that vertical integration will be more ro table to HQ than outsourcing when: 8 h ( + ) + 4 l ( + ) ( ) f I 8 h + 4 l f O + s c h l f I + f O s c 0 4 It is imortant to note that the left hand side of this inequality is increasing in h and decreasing in l, since > 0. The more imortant is the headquarters non-contractable investment relative to that of the hotel roerty s then the higher are oerating ro ts under vertical integration relative to the oerating ro ts under outsourcing. The more imortant is the local roducer s non-contractable investment in the roduction function, HQ has a higher ayo from outsourcing. When h is l high, vertical integration artially mitigates the e ciency loss resulting from the incomleteness of contracts, and the headquarters nds it worthwhile to ay a higher xed cost (E(f I ) > f O ) and 9

10 give u the transfer ayment equivalent to s c to organize roduction in this way. Next, we note that roductivity amli es the e ect of these considerations. The higher is roductivity the larger is the increase in the ayo to HQ from aligning relative investment incentives with relative roduction intensities. Di erentiating the above exression with resect to, we nd that the relative ayo to vertical integration is increasing in if: h l 4 > 0 h 8 + > l 4 h ( + ) > l h l > h l > + r + With a roduction technology that is intensive in headquarter services, the bene t of vertical integration is increasing in roductivity. q Conversely, if the roduction technology is intensive in local roerty services, h <, then outsourcing becomes relatively more ro table to HQ as l + increases. We now allow HQ to create incentives for the local roerty to exert e ort to increase the robability that its investment is high quality. The HQ can use the bonus mechanism to in uence the role layed by x L in the roduction function. In articular, it can use incentives to mitigate the roerty s underinvestment due to the hold u roblem. In GH there is an inverted-u shae relationshi between the relative ro tability of vertical integration and roductivity. We will illustrate how the incentives mechanism in our model can, under certain arameter restrictions, generate a similar non-linear relationshi that can dominate the linear relationshi generated by the roerty rights mechanism in the absence of managerial incentives. For simlicity, we will describe the intuition of the managerial incentive mechanism in the absence of the e ects of the roerty rights mechanism by setting equal to zero. That is, x L and x H are the same under each organizational form. We now allow e ort to determine the robability of high quality x L, and agent e ort to be a ected by incentives rovided in the contract. At low values of, ro ts from outsourcing are greater than the maximum ro ts from vertical integration. Zero e ort is otimal under both organizational forms. No bonus ayment is required in either case. HQ ays a lower set u cost in exectation under outsourcing. At intermediate values of, the maximum ayo from vertical integration is greater than the maximum ro t to outsourcing. HQ must share rents from both tyes of agent to obtain otimal e ort. However, HQ is able to contract with the in-house manager to achieve e cient e ort on a fraction of all tasks without sharing rents with him. For high enough, this bene t will outweigh the higher exected xed costs and lead to higher ro ts under vertical integration. 0

11 At high levels of, the otimal outsourcing contract involves maximum e ort on all tasks. As increases, the HQ has more to gain, even if it ays a bonus, from ensuring e = E is exerted on even the share of tasks that are not directly monitorable under vertical integration. Thus the relative advantage of being able to monitor the e ort exerted on a fraction of tasks under vertical integration disaears. In addition, under outsourcing, HQ is able to extract some u front fee from the agent, s c, and incur lower set u costs. These considerations mean that the maximum ro ts to HQ under outsourcing are greater than under vertical integration at high levels of. In Aendix C, we resent four di erent examles to illustrate outcomes of the model under di erent arameter values of the relationshi between roductivity,, and the relative ro tability of vertical integration and outsourcing..6 Testable Imlications The four cases outline above demonstrate di erent scenarios for ossible relationshi between and the relative ro tability of vertical integration and outsourcing. The greater the di erence in redicted ro tability between organizational form, the larger would have to be the stochastic term seci c to the articular relationshi to overturn the rediction that HQ will select the organizational form redicted to generate the highest ayo to HQ. This tells us that the robability that the HQ will vertically integrate deends on the extent to which the maximum exected ayo to vertical integration as a function of outweighs the maximum exected ayo at that draw to outsourcing. The model hence generates (at least) two related redictions.. For a roduction technology either intensive in HQ or roerty level services, where managerial incentives lays no role in in uencing the choice of organizational form and relationshiseci c investments are determined by the ossibility of hold u in the event of failed bargaining, the robability of vertical integration either increases or decreases with roductivity. There is a monotonic redicted relationshi between and the relative ro tability of vertical integration.. For a roduction technology where HQ is able to o er a contract which a ects roertylevel e ort and the quality of the roerty s relationshi-seci c investment, there will be a non-linear relationshi between the robability of vertical integration and roductivity. Outsourcing will be relatively more ro table to HQ for high and low levels of roductivity,, and vertical integration is relatively more ro table for intermediate levels of roductivity. Since roerty-level total factor roductivity data are not available to use a resent, we test these roositions indirectly by examining the redicted relationshi between the robability of integration and the level of caital investment. In articular, we exloit the fact that the model generates a third rediction: 3. x k increases with.

12 Hence, the model imlies that variations in roductivity induce a relationshi between x k and the robability of vertical integration that is similar to the underlying relationshi between and organizational form. In the second art of the aer, we directly test these redicted relationshis:. For a roduction technology where roerty rights concerns determine the choice of organizational form in the absence of e ective managerial incentives, there is a monotonic relationshi between the robability of integration and the level of caital investment.. For a roduction technology where managerial incentives lay a signi cant role in in uencing the quality of the roerty-level inut (or relationshi seci c investment level), there is a non-monotonic relationshi between the robability of integration and the level of caital investment. In articular, there is an inverted-u shaed relationshi between the two variables such that medium sized hotels are more likely to be vertically integrated. 3 Descrition of Data To test the redictions of the model, we emloy roerty-level data from two hotel rms and from one market research rm. The rimary data include brands and their 68 hotels worldwide. The secondary data include 9 additional brands and their 970 hotels in the US. For each hotel roerty in the dataset, we have data on location (city and country), the number of rooms, and organizational form. In addition, the secondary data also include the oening date of each hotel and the date that the hotel rst became a liated with its current brand. Table 4 summarizes the available information in the rimary and secondary data. Organizational form is a categorical variable, with the categories in the rimary data di ering from the categories in the secondary data. In the rimary data, there is information on two related but distinct dimensions of integration: whether the headquarters owns a hotel roerty and whether the headquarters oerates or manages a hotel roerty. As a result, there are four main categories of hotels: owned, leased, managed, and franchised. For an owned or franchised roerty, one arty owns and oerates the roerty. For an owned roerty, that arty is the headquarters; for a franchised roerty, it is a third arty. For a leased roerty, the headquarters owns the roerty and leases it to a third arty who oerates it. Finally, for a managed roerty, a third arty owns the roerty but the headquarters manages it. In the secondary data, there is information on oeration but not on ownershi. As a result, there are only two categories of organizational form: franchised and chain management. Based on these categories, we create three alternative measures of vertical integration. First, the binary variable VI indicates whether either ownershi or oeration of the hotel roerty is outsourced to a third arty. It is equal to if neither task is outsourced. Second, the binary variable HQOWND indicates whether or not the headquarters owns a hotel roerty. Third, the binary variable HQOPED is an indicator for whether not the headquarters oerates a hotel roerty. Figure summarizes the maing from the categorical variables in the raw data to the binary

13 variables HQOWND and HQOPED. Hotels with a value of for VI are in the to right hand box of the gure. In the secondary data there are only two categories, the two grey-shaded values: "chain management" and "franchised." "Franchised" corresonds to a value of 0 for both HQOPED and HQOWND. "Chain management" corresonds to a value of for HQOPED; the value of HQOWND is unknown in this case. In the rimary data, there are ve categories: managed, rented, owned, leased, and franchised. All of these values are informative about both asset ownershi and organizational control; accordingly, each one mas to HQOPED and HQOWND as shown in Figure. There is an average roensity towards outsourcing in the relevant data for each of the three measure. In the rimary data, only 7% of hotels are entirely vertically integrated, where both ownershi and oeration of the hotel roerty are done in house. Also based on the rimary data, 8% of the hotels are owned by the headquarters. In the comlete data set, 3% of the hotels are oerated by the headquarters. Table 5 resents summary statistics for hotel size, integration, oening date, and a liation date for various subsets of the data. Figures and 3 resent some grahical evidence that variation in organizational form may be associated with hotel size in a manner consistent with the theories. For three di erent brands, Figure shows the roortion of US hotels in each hotel size bin that is owned by HQ. Brands B and C 6 rovide some evidence of an inverted-u shaed relationshi. For Brand C, there aears to be a ositive correlation of the tye redicted by the roerty rights model (for large h ). Figure 3 l shows the same data for ve brands which, on average, have fewer rooms er hotel. Here, we see evidence of an inverted-u shae for Brand B, HOLS (Holiday Inn & Suites) and RADI (Radisson). The attern for the other brands is less clear. These gures suggest that some of the redicted relationshis may obtain in the data. We now turn to a more formal test of those roositions. 4 Estimation Strategy Our deendent variables are binary; vertical integration corresonds to and outsourcing corresonds to 0. We have two alternative deendent variables: HQOWND, and HQOPED. In each case, the outcome of these discrete choices can be seen as re ecting a threshold rule for an underlying latent variable y (Greene, 00), so that y = if y > 0 and y = 0 if y 0. In this case, the vector of latent variables y is the di erence between ro ts under vertical integration and outsourcing. We can write a threshold rule based on the realization of the ro t di erential between the two organizational forms. At di erent levels of, the stochastic elements of the model are di erently likely to overturn the rediction that HQ will choose the organizational form that yields the highest U H, so that if redicted y is ositive, vertical integration will be chosen and if y is negative, outsourcing will be chosen. Since we do not directly observe the ro t di erential y we use the outcome of vertical inte- 6 We obtained rimary data directly from two multinational hotel rms under a strict con dentiality agreement. Accordingly, we disguise the brand names using letter codes. 3

14 gration or outsourcing to infer the arameters in the underlying model. We assume that y is a function of the set of exlanatory variables generated by the model, x; we use the linear aroximation y = 0 x + ". We normalize variables so that " has a standard logistic distribution with mean zero and variance one. We include grou e ects among these exlanatory variables in order to mitigate omitted variable bias. The model imlies that brand and market characteristics other than roductivity may a ect both hotel size and organizational form. For examle, for an HQ-intensive technology, a higher xed cost of entry for a articular brand-country air will increase average hotel size and the average robability of vertical integration. Because we cannot directly measure some of these characteristics, we grou e ects among our exlanatory variables x. E ectively, this allows the roductivity distribution, F (), and other inuts to the various ro t functions to vary by grou. This seci cation swees out the e ects that are common to all observations in each grou; identi cation comes from the within-grou variation in the deendent variables. Given these assumtions, the robability that the l th hotel of the n th grou will be integrated (y nl = ) can be rewritten as: Pr (y nl > 0jx nl ; ) = Pr ( 0 ex nl + n + " nl > 0) = F ( 0 ex nl + n ) (4) where n is a grou seci c incidental arameter common to all other observations in grou n and ex nl consists of the other regressors seci c to hotel l in grou n. In our baseline estimates, we use brand-country grous. In order to control for a wide range of grou e ects, we allow the brand e ect to di er across countries and vice versa. We also erform a robustness check in which we use city and brand grou e ects, in order to control for omitted variables at the sub-country level that may be correlated with size and organizational form. 7 In both cases, the average grou size is not large and there are a number of very small grous. For each of the three measures of vertical integration, Table 3 resents the size of the grous used in our baseline estimates and our check for robustness to controls for otential city-level omitted variables. With HQOWND and brand-country grous, the average grou size is 0, but there are grous with as few as observations. These small grous comlicate our estimation strategy. Conventional maximum likelihood estimation of a non-linear robability model with xed e ects will yield inconsistent arameter estimates, and the roblem is articularly severe in the case of many grous with few observations er grou. This oint is illustrated in Chamberlain (980). Since the bias of the xed e ect estimates is tyically on the order of L n, where L n is the number of observations in the n th grou, the otential for bias is signi cant. Accordingly, we adot the remedy suggested in Chamberlain (980) and emloy a conditional likelihood aroach. 8 In addition, because we 7 A third seci cation using brand-city grous is discussed in Aendix D. We do not have enough within grou variation to identify brand level e ects, but our results remain for the ooled samle. 8 The estimator of generated from the conditional logit maximum likelihood estimation is consistent as long as the conditional likelihood function satis es regularity conditions (Chamberlain, 980). The asymtotic covariance matrix for the estimator of is obtained from the inverse of the information matrix, allowing us to use standard error estimates to make inferences about the e ects of the each of the exlanatory variables in ex on the choice of organizational form, y n;l. 4

15 exlicitly include brand xed e ects in our seci cation with city and brand grou e ects 9, we exclude observations for brands with fewer than 47 observations 0. latter ste excludes only 7 out of 438 observations. Table indicates that this Rewriting the roblem in anel form to illustrate grou a liation, let n = ::::N index the grou, and let l = :::L n index the observations in grou n. We condition the likelihood function on the number of ositive outcomes in each grou n, which is a summary statistic for the grouseci c incidental arameter. Let y n = (y n; ; y n; ; :::y n;ln ) be the series of observed outcomes for the n th grou as a whole. We denote the observed number of ones for the deendent variable in the n th grou as k n = P L n l= y n;l. We are interested in the robability of a ossible set of outcomes y n conditional on the observed value of k n. The conditional likelihood function can be written: L = n Pr! XL n y n j y n;l = k n and is indeendent of n ; the incidental arameters have been swet out of the likelihood function. In the context of a logit model, the conditional robability of observing the series of outcomes y n in grou n, conditional on k n is exressed: Pr! XL n y n j y n;l = k n = l= l= PLn ex P d ns n ex l= y n;lex n;l PLn l= d n;lex n;l (5) (6) where d n;l is equal to 0 or with P L n l= d n;l = k n, and S n is the set of all ossible combinations of k n ones and (L n k n ) zeros. We allow the arameters to di er across brands in our baseline estimation. Our hyothesis is that the most imortant determinants of organizational form vary across brands, so that each theory may better redict outcomes for some brands than it does for others. Using this framework, we estimate reduced form quadratic models of the latent variable ycbl of the following tye: y cbl = cb + ROOMS cbl + + (ROOMS cbl ) + BX [I(z = b)] z ROOMS cbl z= BX [I(z = b)] z (ROOMS cbl ) + cbl (7) z= where I(z = b) is an indicator variable that takes on the value if z = b and the value 0 otherwise, ROOMS cbl is the number of rooms for the l th hotel of the country c -brand b grou n, and cb is the grou e ect for the country c-brand b air. 9 Since the average number of observations er brand is signi cantly greater than the number of observations er city, we choose to condition on the number of ositive outcomes er city. 0 In order to minimize di erences due to samle selection, we dro small brands in both the baseline estimates and the robustness checks. This formulation of the summary notation is taken from Hosmer and Lemeshow (000), equation

16 To test whether the roerty rights e ect in the model dominates the choice of organizational form, we estimate this model and then test the following restriction on the estimated coe cients: for any has the same sign for all values of ROOMS. To test whether the managerial incentives e ect lays a signi cant role in determining organizational form, we test the following two restrictions on the coe cient estimates. First, the estimated coe cient on ROOM S should be ositive and the estimated coe cient on ROOMS should be negative. Second, these coe cients should be such that values > 0 for low values of < 0 for higher 5 Emirical results 5. Vertical integration of ownershi We start by reorting results using the deendent variable HQOWND, indicating whether hotel ownershi is outsourced. First, the relationshi between y and ROOMS is restricted to be the same across brands. Next, we allow this relationshi to di er across brands. Since HQOWND is de ned only for hotel brands in one of the rimary data sources, we have brand-seci c coe cients for ve brands. When we restrict and to be equal across the brands included in the analysis, we do not nd evidence of a linear or quadratic relationshi between the robability of HQ ownershi and hotel size. Column of Table 4 reorts conditional logit estimates of the following quadratic model of the latent variable: y cbl = cb + ROOMS cbl + (ROOMS cbl ) + cbl (8) where ROOMS cbl is the number of rooms for the l th hotel of the country c-brand b grou and cb is the grou e ect for the country c-brand b air. Both and are ositive, but neither is signi cant. When we estimate coe cients searately by brand, we see that di erent brands exhibit di erent atterns. Column of Table 4 reorts conditional logit estimates of the following model: y cbl = cb + ROOMS cbl + + (ROOMS cbl ) + BX [I(z = b)] z ROOMS cbl z= BX [I(z = b)] z (ROOMS cbl ) + cbl (9) z= where I(z = b) is an indicator variable that takes on the value if z = b and the value 0 otherwise, ROOMS cbl is the number of rooms for the l th hotel of the country c-brand b grou, and cb is For Brand K, there is too little variation in the HQOWND variable to identify brand seci c coe cients (only hotel is totally vertically integrated). Hence, we omit this brand from the analysis. 6

17 the grou e ect for the country c-brand b air. It is clear from this table that there are imortant di erences between brands. Table 5 reorts the brand-seci c coe cients for ROOMS and ROOMS corresonding to the sum of the Brand A coe cient and the relevant brand-seci c interaction coe cient: and for brand (Brand A), + and + for brand, and so on. It also reorts the corresonding standard errors and -values. We see coe cients of the same signs from Brand J, The coe cient on ROOMS is negative and signi cant at the 0% level and the coe cient on ROOMS is ositive and signi cant at the 0% level. This U-shaed relationshi is inconsistent with the model redictions coming from the roerty rights or the managerial incentives e ect. 5. Control of oerations Tables 9 and 0 reort the main results using HQOPED, the indicator variable for headquarters control of oerations, as the deendent variable. Again, we rst consider the coe cient estimates averaged over all brands, and then we consider the brand-seci c coe cients. When we estimate coe cients averaged across all brands, we do nd evidence of a highly signi - cant quadratic relationshi between the robability of HQ ownershi and hotel size. Table 6 reorts conditional logit estimates of our quadratic model of the index variable, analogous to (8), where all indeendent variables are de ned as they were in (8). In column of Table 6, we reort these average coe cients. The estimate of is 0:00733 with a standard error of 0:00068 (-value of 0:000), and the estimate of is 0:00000 with a standard error of 0: (-value of 0:000). Together, the coe cient estimates imly that the artial correlation of P r(hqop ED = ) and ROOMS is ositive for ROOMS < 85 and negative for higher values of ROOMS. However, only 7 out of 438 hotels in our samle have at least 85 rooms. Hence, although the signs of these coe cients are consistent with the redictions of the model with a managerial incentives e ect, these results do not strongly distinguish between a monotonic ositive relationshi and an inverted-u relationshi. The results at the samle average level are suggestive but inconclusive. Accordingly, we turn to the brand-seci c estimates. We allow the relationshi between HQOPED and ROOM S to di er across brands, and we subject the model estimates to two tests. First, we estimate the relationshi by brand, and we check the signs of the estimated coe cients on ROOMS and ROOMS for each brand. Second, for the brands for which the redicted signs obtain, we determine whether or not the sign of the artial correlation between HQOPED and ROOM S reverses in samle. Signs of estimated coe cients for ROOMS and ROOMS. When we estimate coe - cients searately by brand, we nd evidence of a quadratic relationshi for 6 of the 4 brands which are included in this analysis 3. From column of Table 6, it is aarent that Brand A (once again the brand whose dummy we omitted) is not one of these brands; the coe cients on ROOMS and 3 Brand J is omitted from this analysis as only one hotel is not oerated by headquarters. 7

18 ROOMS are both ositive but insigni cant. Table 7 reorts brand-seci c coe cients for the remaining brands (obtained by summing coe cients as before) and the corresonding standard errors and -values. For Brand B, Hamton Inn, Hilton, Holiday Inn, Radisson, and Brand C (BR_B, HAMI, HILU, HOLI, RADI, BR_C), the coe cient on ROOMS is ositive and signi - cant at 5 ercent, and the coe cient on ROOMS is negative and signi cant at 5 ercent, which is consistent with a managerial incentives e ect. For Marriott, the coe cient on ROOM S is 0:006 and signi cant at ercent and, while the coe cient on ROOMS is negative as redicted by the managerial incentives theory, it is insigni cant. This attern could be reconciled with either of the two mechanisms. For the remaining 7 brands, none of the coe cient estimates are signi cant. Reversal of sign of artial correlation between HQOPED and ROOM S Next, we consider only the 6 brands for which the redicted signs obtained and the coe cients were signi cant. Using the brand-seci c estimated coe cients for ROOMS and ROOMS, we calculate the redicted value of ROOMS at which the artial correlation between HQOPED and ROOMS reverses sign. We then determine whether or not this reversal occurs within samle. We nd that for all of these 6 brands, the threshold value of ROOMS is within samle; however, a very small ercentage of observations lies to the right of the threshold value for 3 of these brands. For each brand, Table 8 dislays the threshold value of ROOMS, the number of observations for which ROOM S exceeds this value, and the total number of observations. For Hamton Inns, Holiday Inn, and Hilton, the observations lying to the right of the threshold value of ROOMS account for less than % of the samle. For Radisson and Brand C, roughly 5% of the observations are in the region where the artial correlation is negative. Brand B rovides the strongest evidence of an inverted-u; 4% of the samle lies to the right of the threshold value of ROOMS. Thus, Radisson, Brand B, and Brand C exhibit atterns that are consistent with the resence of a signi cant role for managerial incentives. For Hamton Inns, Holiday Inn, and Hilton, on the other hand, the results are consistent with the resence of either mechanism or both. In order to assess the economic signi cance of these results, we estimate the marginal "e ect" (we do not interret the estimates as a direct causal e ect) of a change in ROOMS on the robability of HQ control of oerations. For each of the 7 brands for which we obtained signi cant coe cient estimates, Table 9 shows the standard deviation of ROOM S and the estimated marginal "e ect" evaluated at the mean values of HQOPED and ROOM S. These estimates indicate that for the average size hotel, a increase in size of 0 rooms is tyically associated with a to 4 ercent increase in the robability of HQ control of oerations. 5.3 Robustness checks for control of oerations results We have conducted a series of robustness checks on the results for all the deendent variables, but focus on the robustness of the results with the HQOPED variable. The robustness tests fall into one of two categories. Firstly, we emloy di erent econometric seci cations of the robability model used, to ensure that our results are not seci c to the clogit framework. We use a linear 8