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%