vertical boundaries of the firm
DESCRIPTION
The slide is prepared for Economics of Strategy class in Prasetiya Mulya Business School. In week 4, we discuss about vertical boundaries of the firm which define which activities in the vertical chain a firm should perform itself and which it should purchase from independent firms in the market. This concept is important for firms to formulate strategy.TRANSCRIPT
OUTLINE
• Vertical Chain• Make-or-Buy • Reasons to Buy• Reasons to Make
Raw Materials
Manufacturing
Distribution
Retailing
Upstream
Downstream
VERTICAL CHAIN
Define which activities in the vertical chain a firm should perform itself and which it should purchase from independent firms in the market.
Vertical Boundaries of the firm
How to Organize the Vertical Chain
Make-or-Buy Problem
Firm’s Strategy
Make-or-Buy Fallacies1. Firm should MAKE, rather than BUY, assets that provide competitive advantages
An asset that is easily obtained from the market can’t be a source of competitive advantage, whether the firm makes or buys it
2. Firm should BUY, rather than MAKE, to avoid the cost of making the product
Choosing to buy doesn’t eliminate the expenses of the associated activity, either way the firm will pay the cost
3. Firm should MAKE, rather than BUY, to capture the profit margin of the market firms
Accounting profit vs Economic profit; Barriers to Entry
4. Firm should MAKE, rather than BUY, to insure against the risk of high input pricesThe firm doesn’t need to vertically integrate to eliminate income risk due to the input price fluctuation; it could use long term contracts (example: futures)
5. Firm should MAKE, rather than BUY, to tie up a distribution channel (vertical foreclosure)Competitors may open new channels, cannot increase profits above monopoly profit , possible violation of anti trust laws
REASONS TO BUY1. Economies of Scale and Learning Economies
Market firm can reach MES by producing A*
with lower average cost C*
A firm that requires only A’ to meet its own needs
will have high average cost C’
REASONS TO BUY2. Bureaucracy Effects: Avoiding Agency and Influence Cost
Agency costCost associated with motivation (avoid duty or responsibility, being unproductive or inefficient) and the administrative controls to deter it.
Influence costCost associated with internal lobbying for resources (scare capital).
REASONS TO MAKE1. Limitations in Contracts
a. Bounded Rationality• Individuals have limited capacity to process information, deal with complexity,
pursue rational aims• Individuals cannot foresee all possible contingencies
• Terms like “normal wear and tear” may have different interpretations• Performance cannot always be measured unambiguously
• Parties to the contract may not have equal access to contract-relevant information
• The knowledgeable party can misrepresent information
b. Difficulties Specifying or Measuring Performance
c. Asymmetric Information
REASONS TO MAKE2. Coordination Problem
a. Timing Fitb. Sequence Fitc. Technical Specification Fitd. Color Fit
Coordination is especially important when there are design attributes (attributes that need to relate to each other in a precise fashion.)
Small errors can be extremely costly
REASONS TO MAKE3. Leakage of Private Information
Reluctance of the firm to share private information (production know-how, product design or consumer information)
Firm doesn’t want to compromise the source of their competitive advantage
REASONS TO MAKE4. Transaction costs
Relationship- Specific Assets
Rents and Quasi-Rents
Holdup Problem
Transaction Cost
REASONS TO MAKE4. Transaction costs
Relationship-Specific Asset
An asset that support a particular transaction and cannot be redeployed to another transaction without some sacrifice in productivity or some additional cost.
Site specificity
Physical asset specificity
Human asset specificity
Dedicated assets
REASONS TO MAKE4. Transaction costs
Rents and Quasi Rents
Quantity = 1 mio Market price when Ford doesn’t buy = Pm = $4Average cost = C = $3 Price when Ford buy = P* = $12Investment = I = $8.5 mio
Relationship-specific investment (RSI) amount of investment that cannot be recovered if the firm doesn’t do business with FordRSI = I – Q (Pm – C) = $8.5 mio – 1 mio($4 - $3) = $7.5 mio
Rent profit that the firm expect when the deal with Ford goes wellRent = 1 mio (P*- C) – I = $0.5 mio
Quasi-rent extra profit that you get from when the deal goes well vs profit that the firm would get from its next best alternativeQuasi-rent = [1 mio (P*- C) – I ] - [1 mio (Pm - C) – I ] = 1 mio (P* - Pm) = $ 8 mio
REASONS TO MAKE4. Transaction costsHoldup Problems
When quasi-rent > 0, Ford can benefit by “holding up” its trading partner and capture the quasi-rent for Ford.
It could happen when contracts are incomplete and Ford attempt to renegotiate the terms of deal (for example, offer price between P* and Pm to increase Ford’s profit)
P after renegotiation = $8
Profit = 1 mio ($8 - $3) - $8.5 mio = -$3.5 mio
REASONS TO MAKE4. Transaction 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
