Asset Specificity And The Boundary Of The Firm: Cruise Boats

On a couple of nights of our vacation in Maui, a large cruise boat would be anchored several hundred yards out from Lahaina harbor. Not being familiar with how cruise boats operate, given that neither my husband nor I has ever been on a cruise, we amused ourselves with speculation on several of the operating features of these large vessels. In particular, we wondered about what is obviously one of the most attractive features of such cruises Ė visiting various ports of call along the cruise route. Being entirely unacquainted with cruises, we were intrigued by the variety of ways that the cruise company could arrange the transaction of getting their passengers to and from shore. Do they carry purpose-made boats with them? Do they contract with a local boat company, or the local harbor, for shuttle services? Or is there some other way of doing it that we had not considered?

This question gets directly to the heart of one of the core theoretical questions in new institutional economics Ė the relationship between asset specificity, the boundary of the firm, and vertical integration/contracting out make-or-buy questions. The degree to which firms need specific assets to perform their specific functions, and the extent to which those assets have unique capabilities, interacts with transaction costs of engaging in market transactions to shape the boundary of the firm. There are lots of examples of industries in which asset specificity contributes to firm and industry structure, with examples like petroleum refining and chemical distillation. The issue of asset specificity raises a host of questions, such as

-Can the asset perform any other functions, or is it a single-purpose asset? Clearly the example of petroleum refining is one in which itís pretty much single-purpose. If it is a more flexible asset, it may be less costly to redeploy the asset in some other production process, either by the owner or another firm, and is thus less specific to the production process in question. Furthermore, if the asset can be used simultaneously to perform different functions, then the cost of capital that must be incurred to procure the asset begins to look like more of a bargain.

-Can other firms use the asset as-is, for this or other purposes? In other words, how firm-specific is the asset in question? The canonical example of this question is still controversial for a host of minute reasons, but letís just take it at face value here. For example, if a body shop has a machine special-built to stamp out nameplates for particular automobiles, as did, say, Fisher Body for Chevrolet, the dies with the Chevrolet nameplates are specific to the firm in question. If those dies are built in to the stamping machine, or are very expensive to replace, then the machine is more specific to the particular firm, and more costly to redeploy in production at another firm. If that is the case, the hypothesis goes, then you are more likely to see industries in which firms have more specific assets be either more vertically integrated or more likely to arrange their upstream transactions through long-term contracts. Either of these arrangements is more likely to generate the longer stream of expected revenue to induce the upstream firm to incur the capital cost associated with the specific asset investment.

Now, what does this set of questions have to do with cruise ships and shuttling passengers in and out of various ports of call? Suppose you are calling in five different ports on your cruise around the Hawaiian Islands. The first thing as a cruise operator that you might ask is, how costly is it to arrange with local operators to contract with one in each port for shuttle service? And what happens if three cruise ships all happen to show up in Lahaina at the same time, exceeding the capacity of the shuttle operator? This transaction would require coordination and planning to occur through the market. Thus transaction costs might make contracting out (i.e., buying in the service) a less attractive option. Furthermore, a forward-looking cruise operator might think that small ports of call would have only one potential shuttle operator, which would enable them to charge the cruise operator a high (i.e., monopoly) price for their shuttle service, even if they engaged in a long-term contract. So in looking at the make-or-buy decision, these two factors seem to suggest that buying in the service might not be the most attractive option, compared to making the capital investment that would enable the operator to shuttle passengers to and from shore independently.

OK, now we have to think about the investment decision facing the cruise operator so that we can see whether or not the “buy” decision is as bad as Iíve laid it out above. What kind of craft do you need to shuttle passengers to and from shore? Does it have to be purpose-built, thereby adding to the weight and cargo that you carry (which itself has an opportunity cost)? Or can you use vessels that you already are going to have on board, and which thus have no opportunity cost? In this case, the answer is yes Ė you can use your lifeboats! Gotta have Ďem for safety and insurance purposes, so the marginal cost of operating them to shuttle people to shore is only the crew time and fuel cost, and since you have to have them anyway, the opportunity cost is zero.

Whatís interesting about this solution is that itís not a firm-specific or purpose-specific asset, except for it being a vessel capable of taking a certain number of people across water for a certain distance. So, if you will, the vertical integration of the cruise operator into the shore shuttle transaction seems not to result from the degree of asset specificity, but rather from the transaction costs associated with contracting for independent shuttle services.

And as an added bonus, the shipís crew and the passengers going ashore get familiar with the safety procedures and ingress and egress of the lifeboats. This is a great side benefit since there have been several lifeboat launch problems during emergencies over the history of ocean liners.

Many thanks to our knowledgeable and friendly server at PacificíO, a wonderful restaurant in downtown Lahaina on the beach, for enlightening us on the use of lifeboats for shuttling passengers while he also provided superb service, food, and wine. If you look at the menus that they have on their website, we recommend the Hapa Hapa Tempura, which had the most fantastic taste and texture.