You are being assigned to a new project by your employer, OrgDesign Assoc. Specifically, your assignment concerns a project with a new US client, MagazineAds. MagazineAds is a major advertising company with more than 700 employees. It has mainly been active in the creation of advertising campaigns for sports equipment aimed at magazines like Men’s Health. MagazineAds is now turning its attention to producing video advertising campaigns aimed at the internet (e.g., for YouTube). These campaigns are based on small films with professional actors demonstrating the uses, health benefits, etc. of a given product. MagazineAds wishes to continue its focus on mainly sports equipment, in particular, “hardware” like workout machines, skiing equipment, etc. To realize this strategy, MagazineAds deems that it has to combine its existing capabilities in creating advertising campaigns with capabilities in identifying, training, and directing talent (actors, actresses) for its videos, as well as capabilities in the basic production of the videos. MagazineAds has therefore made initial contact to a small but established company, Artists, Inc, which is basically an agency that identifies, selects, hires, and directs talent for advertising videos, and produces the videos. It is a convenient partner as its offices and studios are located on the same block as MagazineAds, just 150 meters away. Artists, Inc. employs 25 people. Most of these have been with the company for more than a decade. In spite of its relatively small size, Artists, Inc is very highly respected and its brandname has very high recognition in both the advertising business and among actors and movie producers. In order to realize a successful collaboration, MagazineAds management realizes that there is a need to build shared understanding and overlapping capabilities and routines that can ensure coordination between the parties. Otherwise, it will not be possible to sufficiently integrate the acting side of successful commercials in a video or film format with the requirements of customers and the concepts developed in response to customer requirements. The contracting default is the existing industry standard. Under this standard, a buyer of a video-based advertising campaign pays a money sum up-front, and based on an estimate computed by the advertising agency (e.g., MagazineAds) of the total costs of production of producing and running a campaign. Such estimates are quite uncertain, because many uncertain factors may influence the cost of production. For example, the initial concept may have to be modified if it is seen as projecting old-fashioned or controversial values with respect to gender, sexuality, etc., if participating talent get caught up in scandals, or similar. Such modifications influence costs in ways that are hard to predict. Among the cost items are the salaries for employees who are employed by the agency, the costs incurred by an agency like Artists, Inc when hiring, directing, etc. talent for the advertising videos, paying for the use of locations, and so one. On average, such up-front payments cover half of the estimated cost of production. In addition to the fixed up-front payment, agencies such as MagazineAds receive a variable payment, which is based on, first, the number of people who have viewed the relevant videos, and, second, the quality of video. Thus, an agency will receive a certain payment (e.g., 250,000 USD) when a certain threshold of unique views is reached within a given geographical market (e.g., one million views across California and Nevada). Additionally, the standard contract specifies a payment for every increment of views (e.g., increments of 5,000 unique viewers may mean that MagazineAds receive an additional 2,500 USD for each increment). With respect to the other part of the variable payment, an agency like MagazineAds will receive a fixed payment of 200,000 USD when the ad has a high recollection rate, if many viewers watch it until it ends (instead of pressing “skip ad”), and it receives overall positive ratings. A specialized, independent rating agency handles the relevant data that underlie this second part of the variable payment. While the customer typically chooses the rating agency, the advertising agency needs to approve the choice before a contract can be made. The metrics put together by the rating agency are strongly influenced by a number of factors other than the quality of the video and the products that are being advertised. Thus, weather conditions (what is the outside temperature when the video is being watched? Is it sunny?) has been shown to play a role, as has the main stories in the news, whether good or bad. MagazineAds realizes that contracting in the creative industries can be hazardous, and it is not entirely comfortable with the default contracting arrangement (as sketched above). Therefore, it is now seeking your advice regarding how to best organize the transactions between itself and Artists, Inc. What will you tell MagazineAds? MagazineAds faces a critical decision in determining how to structure its collaboration with Artists, Inc., a small yet respected video production company. This partnership is essential for expanding MagazineAds’ capabilities into video advertising, aligning with its strategic focus on internet campaigns for sports equipment. The key challenge is choosing an efficient governance structure—whether to rely on market contracts, establish a hybrid arrangement, or vertically integrate Artists, Inc. into MagazineAds. This decision hinges on addressing transaction-specific investments, handling uncertainty, and mitigating moral hazard and adaptation issues. The collaboration requires significant relation-specific investments. Both parties need to build shared understanding and overlapping capabilities to integrate MagazineAds’ advertising expertise with Artists, Inc.’s creative and production skills. These investments are highly specialized and would lose much of their value if the relationship dissolved, making them vulnerable to hold-up problems. Furthermore, the creative nature of the industry introduces uncertainties, such as changing social sentiments or scandals, which complicate the enforcement of comprehensive contracts. Payments tied to metrics like viewership and ad quality are influenced by external factors such as weather or news events, adding an element of risk to the created surplus and raising concerns about both parties' incentives to invest and exert effort. From a theoretical perspective, transaction cost economics emphasizes balancing the need for strong investment incentives with minimizing costs of monitoring and adapting to uncertainty. Property rights theory suggests that ownership should be allocated to the party whose investments are most critical to the relationship’s value. Market contracts preserve Artists, Inc.’s autonomy but may discourage the necessary investments due to fears of ex-post bargaining and opportunism. Hybrid arrangements, such as joint ventures, could facilitate shared investments while maintaining some autonomy. However, they remain vulnerable to incomplete contracts and coordination challenges. Vertical integration, on the other hand, could mitigate hold-up risks, improve coordination, and streamline adaptation processes. Yet, this approach risks weakening Artists, Inc.’s intrinsic motivation by replacing high-powered market incentives with lower-powered internal incentives. Given these considerations, MagazineAds should adopt a flexible approach. While vertical integration offers strong advantages for securing specific investments and managing uncertainty, it may diminish the creative drive crucial to Artists, Inc.’s success. Conversely, hybrid arrangements can strike a balance between coordination and autonomy, but they require carefully designed contracts to address investment and incentive issues. Ultimately, MagazineAds should collect more information to evaluate the costs of internal control versus the risks of hold-up and underinvestment. This analysis will help determine whether the value of integration outweighs its drawbacks or if a well-structured hybrid model is more efficient for fostering collaboration with Artists, Inc.