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Economics of Strategy Fifth Edition

Slides by: Richard Ponarul, California State University, Chico

Copyright 2010 John Wiley Sons, Inc.

Chapter 5

The Vertical Boundaries of the Firm

Besanko, Dranove, Shanley and Schaefer

The Vertical Chain

The vertical chain

begins with the acquisition of raw materials and

ends with the sale of finished goods/services.

Organizing the vertical chain is an important part of business strategy

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The Vertical Chain

Vertically integrated firms (Scott Paper) perform all the tasks in the vertical chain in-house.

Vertically disintegrated firms (Nike) outsource most of the vertical chain tasks.

Vertical Boundaries of the Firm

Vertical boundaries of the firm demarcate which tasks in the vertical chain are to be performed inside the firm and which to be out-sourced.

The choice is between the market and the organization is a make or buy decision.

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Make versus Buy

There is a continuum of possibilities between the two extremes

Arms length transactions

Long term contracts

Strategic alliances and joint ventures

Parent/subsidiary relationship

Activity performed internally

Upstream, Downstream

Early steps in the production process are upstream (Timber for furniture)

Later steps are downstream (finished goods in showrooms)

Support services are provided all along the chain

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Make-or-Buy Continuum

Vertical Chain of Production

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Support Services

Accounting

Finance

Legal Support

Marketing

Planning

Human Resource Management

Defining Boundaries

Firms need to define their vertical boundaries.

Outside specialists who can perform vertical chain tasks are market firms.

Market firms are often recognized leaders in their field (Example: UPS).

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Market Firms

Benefits of using market firms Economies of scale achieved by market firms

Value of market discipline

Costs Problems in coordination of production flows

Possible leak of private information

Transactions costs

Some Make-or-Buy Fallacies

Firm should make rather than buy assets that provide competitive advantages

Outsourcing an activity eliminates the cost of that activity

Making instead of buying captures the profit margin of the market firms

Vertical integration insures against the risk of high input prices

Making ties up the distribution channel and denies access to the rivals

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Make-or-Buy & Competitive Advantage

A firm may believe that a particular asset is a source of competitive advantage

But if the asset is easily available in the market the belief regarding competitive advantage will have to be reevaluated

Outsourcing and Cost

It should not matter if the costs of performing an activity are incurred by the firm (Make) or by the supplier (Buy)

The relevant consideration is whether it is more efficient to make or to buy

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Vertical Integration and Profits

The supplier’s profit margin may not represent any economic profit, and profit margin should “pay” for the capital investment and the risk borne

If the supplier is earning economic profit, is there a reason for its persistence?

Market competition should eventually erode away any economic profit

Vertical Integration & Input Price Risk

Instead of vertical integration, long term contracts can be used to reduce input price risk

Forward or futures contracts can also be used to hedge input price risk

Alternately the capital tied up in vertical integration could be used as a contingency fund to deal with price fluctuations.

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Foreclosure of Distribution Channels

Acquiring a downstream monopoly supplier may seem to be a way to tie up channels and increase profits

Three possible limitations

Possible violation of anti trust laws

Price paid for the downstream firm may reflect the full value of the monopoly power

Competitors may be able to open new distribution channels

Foreclosure of Distribution Channels

Foreclosure can succeed if:

Upstream monopolist is unable to commit to higher prices (discounting to more price sensitive buyers)

Upstream firm is creating a network by acquiring several downstream firms

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Reasons to Buy

Market firms may have patents or proprietary information that makes low cost production possible

Market firms can achieve economies of scale that in-house units cannot

Market firms are likely to exploit learning economies

Economies of Scale

Production Costs and the Make-or-Buy Decision

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Economies of Scale

A given manufacturer of automobiles needs A’ units

An outside supplier may reach the minimum efficient scale (A*) by supplying to different automobile manufacturers

The cost is lowered by using the outside supplier

Economies of Scale

Minimum efficient scale may be feasible for the independent supplier but not for an automobile manufacturer.

Automobile manufacturers would rather buy anti-lock brakes from an independent supplier than from a competitor.

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Economies of Scale

Will the outside supplier charge C* (its average cost) or C’ (the average cost for the manufacturer for in-house production)?

The answer depends on the degree of competition faced by the supplier

Agency Costs

Agency costs are due to slacking by employees and the administrative effort to deter slacking.

When there are joint costs measuring and rewarding individual unit’s performance is difficult.

It is difficult to internally replicate the incentives faced by market firms

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Agency Costs

It can be difficult to evaluate the efficiency when a task is performed by a “cost center” within an organization.

Inherent advantages enjoyed by the firm in the market allows its managers to live with the agency costs

Influence Costs

Performing a task in-house will lead to influence costs.

Internal Capital Markets allocates scarce capital within the firm

Allocations can be favorably affected by influence activities

Resources consumed by influence activities represent influence costs.

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Influence Costs

In-house suppliers can use their influence with headquarters to shield against pressures to become more competitive.

Large vertically integrated firms are more prone to influence cost problems than small independent firms.

Reasons to Make

Costs imposed by poor coordination

Reluctance of partners to develop and share private information

Transactions cost that can be avoided by performing the task in-house

Each of the three problems can be traced to difficulties in contracting

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Role of Contracts

Firms often use contracts when certain tasks are performed outside the firm.

The contracts list

the set of tasks that need to be performed and

the remedies if one party fails to fulfill its obligation.

Contracts

Contracts protect each party to a transaction from opportunistic behavior of other(s)

Contracts’ ability to provide this protection depends on

the “completeness” of contracts

the body of contract law

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Complete Contract

A complete contract stipulates what each party should do for every possible contingency

No party can exploit others’ weaknesses To create a compete contract one should be

able to contemplate all possible contingencies

Complete Contract (Cont.)

A complete contract maps each possible contingency to a set of stipulated actions

One should be able to define and measure performance

The contract must be enforceable

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Complete Contract (Cont.)

To enforce a contract, an outside party (judge, arbitrator) should be able to

observe the contingency

observe the actions by the parties

impose the stated penalties for non-performance

Real life contracts are usually incomplete contracts

Incomplete Contracts

Incomplete contracts involve some ambiguities

They do not anticipate all possible contingencies

They do not spell out rights and responsibilities of parties completely

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Factors that Prevent Complete Contracting

Bounded rationality

Difficulties in specifying/measuring performance

Asymmetric information

Bounded Rationality

Individuals have limited capacity to

process information

deal with complexity

pursue rational aims

Individuals cannot foresee all possible contingencies

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Specifying/Measuring Performance

What constitutes fulfillment of a contract may have some residual vagueness.

Terms like “normal wear and tear” may have different interpretations.

Performance cannot always be measured unambiguously.

Asymmetric Information

Parties to the contract may not have equal access to contract-relevant information.

The knowledgeable party can misrepresent information with impunity.

Contracting on items that rely on this information is difficult.

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Contract Law

Contract law facilitates transactions when contracts are incomplete.

Parties need not specify provisions that are common to a wide class of transactions.

In the U. S. contract law is embodied in common law and the Uniform Commercial Code.

Limitations of Contract Law

Doctrines of contract law are in broad language that could be interpreted in different ways

Litigation can be a costly way to deal with breach of contract

Litigation can be time consuming

Litigation weakens the business relationship

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Coordination of Production Flows

Firms make decisions that depend in part on the decisions made by other firms along the vertical chain.

A good fit will have to be accomplished in all dimensions of production. (Examples: Timing, Size, Color and Sequence)

Coordination Problems

Without good coordination, bottlenecks arise in the vertical chain

To ensure coordination, firms rely on contracts

Firms also use merchant coordinators – independent specialists who work with firms along the vertical chain

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Coordination Problems

Coordination is especially important when design attributes are present

Design attributes are attributes that need to relate to each other in a precise fashion. Some examples are:

Fit of auto sunroof glass to aperture

Timely delivery of a critical component

Small errors can be extremely costly.

Design Attributes

If coordination is critical, administration control may replace the market mechanism

Design attributes may be moved in-house

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Leakage of Private Information

Firms do not want to compromise the source of their competitive advantage .

Private information on product design or production know-how may be compromised when outside firms are used in the vertical chain.

Leakage of Private Information

Well defined patents can help but may not provide full protection

Contracts with non-compete clauses can be used to protect against leakage of information

In practice, non-compete clauses can be hard to enforce

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Transactions Costs

If the market mechanism improves efficiency, why do so many of the activities take place outside the price system? (Coase)

Costs of using the market that are saved by centralized direction – transactions costs

Outsourcing entails costs of negotiating, writing and enforcing contracts

Transactions Costs

Costs incurred due to opportunistic behavior of parties to the contract and efforts to prevent such behavior are transaction costs as well.

Transactions costs explain why economic activities occur outside the price system (inside the firm).

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Transactions Costs

Sources of transactions costs

Investments that need to be made in relationship specific assets

Possible opportunistic behavior after the investment is made (holdup problem)

Quasi-rents (magnitude of the holdup problems)

Relationship-Specific Assets

Relation-specific assets are assets essential for a given transaction

These assets cannot be redeployed for another transaction without cost

Once the asset is in place, the other party to the contract cannot be replaced without cost, because the parties are locked into the relationship to some degree

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Forms of Asset Specificity

Relation-specific assets may exhibit different forms of specificity

Site specificity

Physical asset specificity

Dedicated assets

Human asset specificity

Site Specificity

Assets may have to be located in close proximity to economize on transportation costs and inventory costs and to improve process efficiency

Cement factories are usually located near lime stone deposits

Can-producing plants are located near can-filling plants

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Physical Asset Specificity

Physical assets may have to be designed specifically for the particular transaction

Molds for glass container production custom made for a particular user

A refinery designed to process a particular grade of bauxite ore

Dedicated Assets

Some investments are made to satisfy a single buyer, without whose business the investment will not be profitable.

Ports investing in assets to meet the special needs of some customers

A defense contractor’s investment in manufacturing facility for making certain advanced weapon systems

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Human Asset Specificity

Some of the employees of the firms engaged in the transaction may have to acquire relationship-specific skills, know-how and information Clerical workers acquire the skills to use a

particular enterprise resource planning software

Salespersons posses detailed knowledge of customer firm’s internal organization

Fundamental Transformation

Prior to the investment in relationship specific assets there are many trading partners.

Once the investment is made the situation becomes a bargaining situation with a small number partners

Relationship specific assets cause a fundamental transformation in the relationship

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Rents and Quasi-Rents

The term rent denotes economic profits – profits after all the economic costs, including the cost of capital, are deducted

Quasi-rent is the excess economic profit from a transaction compared with economic profits available from an alternate transaction

Rents and Quasi-Rents

Firm A makes an investment to produce a component for Firm B after B as agreed to buy from A at a certain price

At that price A can earn an economic profit of π1

If B were to renege on the agreement and A is forced to sell its output in the open market, the economic profit will be π2

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Rents and Quasi-Rents

Rent is the minimum economic profit needed to induce A to enter into this agreement with B (π1)

Quasi-rent is the economic profit in excess on the minimum needed to retain A in the selling relationship with B (π1- π2)

The Holdup Problem

Whenever π1 > π2, Firm B can benefit by holding up A and capturing the quasi-rent for itself

A complete contract will not permit the breach.

With incomplete contracts and relationship-specific assets, quasi-rent may exist and lead to the holdup problem

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Effect on Transactions Costs

The holdup problem raises the cost of transacting exchanges

Contract negotiations become more difficult

Investments may have to be made to improve the ex-post bargaining position

Potential holdup can cause distrust

There could be underinvestment in relationship specific assets

Holdup and Contract Negotiations

When there is potential for holdup, contract negotiations become tedious as each party attempts to build in protections for itself

Temptations on the part of either party to holdup can lead to frequent renegotiations

There could be costly disruptions in the exchange

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Holdup and Costly Safeguards

Potential for holdup may lead parties to invest in wasteful protective measures

Manufacturer may acquire standby production facility for an input that is to be obtained from a market firm

Floating power plants are used in place of traditional power plants to avoid site specific investments

Holdup and Distrust

Potential holdups cause distrust between parties and raise the cost of transactions

Distrust can make contracting more costly since contracts will have to be more detailed

Distrust affects the flow of information needed to achieve process efficiencies

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Holdup and Underinvestment

When there is a holdup, the investment made in relationship-specific assets loses value

Anticipating holdups, firms will make otherwise sub-optimal level of investments and suffer higher production costs

The Holdup Problem: Summary

Relation-specific assets support a particular transaction

Redeploying to other uses is costly Quasi rents become available to one party

and there is incentive for a holdup Potential for holdups lead to Underinvestment in these assets Investment in safeguards Reduced trust

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Double Marginalization

Vertical integration helps if both the upstream firm and the downstream firm have market power

Upstream firm sets its price above marginal cost

Vertical integration increases output, lowers the final price and increases the profits

The Make-or-Buy Decision Tree