economics of strategy slide show adapted on basis of that prepared by richard ponarul california...
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Economics of Strategy
Slide show adapted on basis of that prepared by
Richard PonArulCalifornia State University, Chico John Wiley Sons, Inc.
Chapter 4
Organizing Vertical Boundaries:Vertical Integration and its Alternatives
Besanko, Dranove, Shanley and Schaefer, 3rd Edition
Introduction
There are various approaches in considering the merits of vertical integration
– balancing transactions costs (O. Williamson)– role of asset ownership (S.Grossman, O.Hart, J.Moore)
These two approaches generate also two different theories of the firm
There are also alternatives to vertical integration– tapered integration– joint ventures– networks– implicit contracts
Vertical Boundaries
For each step in the vertical chain the firm has to decide between market exchange and vertical integration
The degree of vertical integration differs– Across industries– Across firms within an industry– Across transactions with in firm
We consider an upstream firm and a downstream firm
The Tradeoff in Vertical Integration
Using the market improves technical efficiency (least cost production) – it relates to production
Vertical integration improves agency efficiency (coordination, transactions costs) – it relates to exchange
Firm should “economize” - choose the best possible combination of technical and agency efficiencies
Technical Efficiency
Using the market leads to higher technical efficiency compared to vertical integration (power of market discipline)
The difference in technical efficiency of market over vertical integration (T) depends on the nature of the assets involved in production (ie. production of the intermediate product by the upstream firm)
Technical Efficiency
As the assets become more specialized the market firm’s economies of scale become weaker
The difference in technical efficiency of market over vertical integration (T) declines with greater asset specificity
Agency Efficiency
At high levels of asset specificity, differential agency efficiency of market over vertical integration (A) is negative
When specialized assets are involved, potential for a holdup is high and the result is higher transactions costs
Agency Efficiency
At low levels of asset specificity, differential agency efficiency of market over vertical integration (A) is likely to be positive
Without the holdup problem, market exchange could be more agency efficient than in-house production (due to intra-firm agency and influence costs).
Efficiency Tradeoff
The combined (market over vertical integration) differential efficiency (C) will be negatively related to asset specificity
At high levels of assets specificity vertical integration is more efficient
At low levels of assets specificity outsourcing wins
An illustration
$
k
k measures asset specificity
T
T gives the difference in minimum production cost from internal versus external production
T > 0: internal production costs are
never lower than external - economies of
scale
A gives the difference in agency costs from internal versus external production
A
If the input is purchasedfrom an outside supplier
agency costs includenegotiation, writing and
enforcing contracts
If the input is purchasedfrom an outside supplier
agency costs includenegotiation, writing and
enforcing contracts
If the input is sourcedinternally agency costs
are the agency andinfluence costs discussed
before
If the input is sourcedinternally agency costs
are the agency andinfluence costs discussed
beforeWhen the degree ofasset specificity is
low A > 0
When the degree ofasset specificity is
low A > 0When the degree
of asset specificity ishigh A < 0
When the degree of asset
specificity ishigh A < 0
C is the vertical sum of T and A. It is the difference between production and exchange costs with vertical integration and these costs with market exchange
C
k*
k**
When the degree of asset specificity is less than k*
market exchange has lowertransactions costs
When the degree of asset specificity is less than k*
market exchange has lowertransactions costs
When the degree of asset specificity is less than k**
market exchange is thepreferred mode
When the degree of asset specificity is less than k**
market exchange is thepreferred mode
When the degree of asset specificity is greater than k**
vertical integration is thepreferred mode
When the degree of asset specificity is greater than k**
vertical integration is thepreferred mode
Vertical integration is preferable when
economies of scale areweak and asset specificity
is high
Technical and Agency Efficiency
Efficiency Tradeoff and Scale
When the scale of production of the downstream firm increases, the vertically integrated firm enjoys better economies of scale
With increased scale, the differential technical efficiency decreases for every level of asset specificity (the T curve shifts downward)
Efficiency Tradeoff and Scale
With an increase in scale, the differential agency efficiency becomes more sensitive to asset specificity
Differential agency efficiency (market over vertical integration) will increase with scale for low asset specificity
With high asset specificity, differential agency efficiency decreases with scale
→ A curve twists clockwise through point k*
Efficiency Tradeoff and Scale
The combined differential efficiency (C) sharply declines for low asset specificity
→ C curves shifts downward and becomes less steep
The degree of asset specificity at which market is just competitive with vertical integration declines (from k** to k***)
Vertical integration is preferred to market exchange over a larger range of asset specificity
The illustration (cont.)
$
k
Now consider the impact of marketgrowth on the internal/external choice
T
A
C
k*
k**
k***
An increase in market size causes T to fall
An increase in market size accentuates the advantage of the mode of production with lower exchange costs and so twists A around k*
The overall effect is to change C and move k** to the left to k***
An increase in market sizereduces the critical degree ofasset specificity above which
vertical integration ispreferred
Vertical integration (cont.)
Three important conclusions
Scale and scope economies at intermediate input level
– gain less from vertical integration when scale and scope economies are strong
Product market scale and growth– gain more from vertical integration in large and growing markets
Asset specificity– gain more from vertical integration when production involves
investment in relationship-specific assets
Real-World Evidence
GM is more vertically integrated than Ford is, for the same asset specificity (scale)
In aerospace, greater design specificity increases the likelihood of vertical integration of production
Among utilities, mine-mouth plants are more likely to be integrated compared with other plants
The Virtual Corporation (Davidow-Malone, 1992)
Advances in technology have reduced coordination costs and reduced asset specificity
Consequently, the advantage of market over vertical integration has steadily increased
Virtual corporation is the limit when each element in the vertical chain will be independent
Vertical Integration and Asset Ownership
Grossman-Hart-Moore (GHM) adopt a different approach to study vertical integration:
Make-or-buy decision is essentially a decision regarding ownership rights: if right of use is granted the owner retains residual rights of control (i.e.. Rights of control on what is not explicitly stipulated on the contract)
cont.
Vertical Integration and Asset Ownership
If contracts were complete, it will not matter who owned the assets in the vertical chain
With incomplete contracts, ownership pattern determines the willingness of each party to make relationship-specific investments
Vertical Integration and Asset Ownership
Three ways to organize a transaction in the vertical chain– The two units are independent (non integration)– Upstream unit owns the assets of the downstream
unit (forward integration)– Downstream unit owns the assets of the upstream
unit (backward integration)
Asset Ownership and Integration
Possession of residual control improves bargaining power over operating decision
The form of integration affects the incentives to invest in relationship-specific assets
Whether vertical integration is optimal or not depends on the relative contribution to value added by each party’s investment
Asset Ownership and Integration
If the investments by the upstream player and the downstream player are of comparable importance, market exchange is preferred
If the investment by one player is more important in value creation, vertical integration is preferred
Asset Ownership and Integration
Asset ownership is an important dimension of vertical integration
There could be degrees of integration depending on the extent of control over specialized assets– Example: Auto manufacturers can use
independent suppliers for body parts but own the dies and stamping machines
Vertical Integration in Insurance Industry
In whole life insurance, sales agents’ efforts in renewal are unimportant and insurers tend to use in-house sales forces and tend to own client lists
In term life insurance, renewal efforts are more important and independent agents who own client lists are used
Human Assets and Vertical Integration
When physical assets are involved, upstream (or downstream) asset ownership can be used along with market exchange
When human assets are important, acquiring control of these assets can be done only through a full fledged vertical integration
Process Issues in Vertical Mergers
The desirability of a vertical merger is affected by its impact on technical and agency efficiency
It is also affected by governance issues– managers of the acquired unit have to cede control post-
merger– but they must be given decision-making power
commensurate with their control over specialized resources e.g. human capital
– decision-making rights should be given to managers with the greatest influence in performance and profitability
if success depends on synergies associated with physical assets, centralize
if success depends on specialized knowledge of acquired managers, decentralize
Process issues (cont.)
The governance structure that emerges may well exhibit path dependence
– past circumstances determine governance structure immediate post-merger conflict undermines the potential for
future cooperation– affects relationship between parent and a spun-off unit
may maintain long-term informal association– affects capacity to sell outside the vertically integrated unit
internal division does not usually have this expertise: the external market is a distraction
an acquired supplier does have this expertise: it had marketing capacity prior to acquisition
Alternatives to Vertical Integration
Tapered integration (making some and buying the rest)
Joint ventures and strategic alliances Long term collaborative relationships Implicit contracts between firms
Tapered Integration
A firm may produce part of its input on its own and purchase the rest
A firm may sell part of its output through in-house sales efforts and sell the rest through independent distributors
Tapered Integration: Advantages
Additional input/output channels without massive capital investments
Information about costs and profitability from internal operations can help in negotiating with market firms (threat of self manufacture can discipline external channels) and external supplier can be a yardstick to control internal division.
Internal supply capabilities will protect against potential holdups
Tapered Integration: Disadvantages
Possible loss of economies of scale Coordination may become more difficult
since the two production units must agree on product specifications and delivery times
Managers may be self-serving in continuing with internal production well after it has become inefficient to do so
Tapered Integration in Gasoline Retailing
Major oil refiners sell through their own service stations and through independently owned stations
As gas stations have moved away from auto repair and maintenance services, the proportion of company owned stations are growing
Strategic Alliances and Joint Ventures
Alliances involve cooperation, coordination and information sharing for a joint project while the participating firms continue to be independent
A joint venture is an alliance where a new independent organization is created and jointly owned by the promoting firms
Strategic Alliance
Alliances and joint ventures are intermediate solutions, between market exchange and vertical integration
Rather than rely on contracts, an alliance relies on trust and reciprocity
Disputes are rarely litigated but resolves through negotiation
Strategic Alliance – Advantages
Transactions that are natural candidates for alliances have compelling reasons to both make and buy:
Uncertainty surrounding future activities prevents the parties from going into the specifics of those decisions in a contract
Transactions are complex and one cannot count on contract law to “fill the gaps”
Existence of relationship-specific assets and potential holdup problem
Strategic Alliance - Advantages
Any one party does not have the expertise to organize the transaction internally
Market opportunity that induced the transaction is not expected to last very long making a long term contract or merger unattractive
Regulatory environment necessitates acquiring a local partner for the venture
Strategic Alliance - Costs
There are drawbacks– risk of leakage of information and loss of control of
proprietary information the alliance usually requires extensive information sharing
between independent firms
– efficient coordination may be difficult to achieve no formal mechanism for resolving disputes
– suffers from agency and influence costs effort split across independent firms potential free-rider problem: neither party has the incentive
to monitor effectively because they not not keep all the benefits
Collaborative Relationships
Japanese industrial firms appear to be smaller and less vertically integrated compared to their western counterparts
Japanese firms organize the vertical chain using long term collaborative relationship among firms rather than arm’s length transactions
Collaborative Relationships
Two major types of collaborative relationships are found in Japan– Subcontractor networks– Keiretsu
Subcontractor Networks
Japanese manufacturers maintain close, informal, long term relationship with their network of subcontractors
The typical relationship between a manufacturer and a subcontractor involves far more asset specificity in Japan than in the West Example, UK vs Japan in electronics:– short-term, narrowly defined– mediated by contractual rather than informal
arrangements
Keiretsu
Member firms of a keiretsu hold each other’s equity
Links among firms are further strengthened by personal relationships among top executives
Most of the key activities in the vertical chain are performed by members of the keiretsu with easy coordination and no chance for holdups
KeiretsuFormal, institutionalized relationship with complex linkages
TradingCompanies
TradingCompanies
Manuf’gCompanies
Manuf’gCompanies
Other financialinstitutions Banks
Life insurancecompanies
Satellite Companies
Loans
Equityholdings
Trade
Implicit Contracts
Implicit contracts are unstated understanding between firms in a business relationship
Longstanding relationship between firms can make them behave cooperatively towards each other without any formal contracts
Implicit Contracts
The threat of losing future business (and the future stream of profits) is enough to deter opportunistic behavior in any one period
The desire to protect one’s reputation in the market place can be another mechanism that makes implicit contracts viable
An illustration
UpstreamSupplier
UpstreamSupplier
DownstreamFirm
DownstreamFirm
FinalConsumers
FinalConsumers
Profit p.a.$1 million
Profit p.a.$1 million
Profit p.a.$1 million
Profit p.a.$1 million
Both parties have alternativetrading partners with profitsof $900,000 p.a. if forced to
switch
Both parties have alternativetrading partners with profitsof $900,000 p.a. if forced to
switch
Both parties can increaseprofits to $1.2 million byreducing commitment to
the relationship
Both parties can increaseprofits to $1.2 million byreducing commitment to
the relationship
Should commitmentbe reduced?
Should commitmentbe reduced?
Gain: one-off increase of $200,000
Loss: long-term loss of $100,000 from collapse of relationship
Present value of loss = $100,000/r
Stick with the implicit contract
so long as r < 50%
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