vertical scope of the firm what are the appropriate (efficient) organizational boundaries of the...

Vertical Scope of the Firm

What are the appropriate (efficient) organizational boundaries of the

firm?

Vertical Scope of the Firm 2

Voigt, Fall, 1998

VERTICAL PRODUCT GEOGRAPHICAL AREAS

SINGLEFIRM

SEVERAL SPECIALIZED FIRMS

V1

V2

V3

V1

V2

V3

P1 P2 P3 A1 A2 A3

P1 P1 P1 A1 A2 A3

Transaction Costs and the Scope of the Firm

In relation to each dimension of scope, the basic issue is relative efficiency of the single firm compared with several specialist firms.

Common Issue: What are transactions costs of markets compared with administrative/governance costs of the firm?

Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995


Voigt, Fall, 1998

Creating Efficiently Designed Corporations

The corporate hierarchy will be efficient when it can be shown to be the organizational arrangement that minimizes the sum of production and governance costs. Production costs are the direct costs incurred in the physical production and exchange of the item subject to the transaction. Governance costs include costs of negotiating, writing, monitoring, enforcing, and possibly also bonding to the terms of the organizational arrangement.

Historically, production costs were the primary drivers of firm boundaries. More recently, attention has been placed on governance costs.

Source: Collis and Montgomergy, Corporate Strategy, 1997


Voigt, Fall, 1998

Vertical integration (VI) is a firm’s ownership of vertically related activities.

Vertical integration can occur in 2 directions:

• Backward Integration (producing own inputs)

• Forward Integration (disposing of own outputs)


Defining Vertical Integration


Voigt, Fall, 1998

Benefits of Vertical Integration

Economies of combined operations

Economies of internal control and coordination

Assure supply or demand

Better quality control and coordination

Protect proprietary technology

Gain access to information

Avoid costs of dealing with the market

Gain (or offset) market power



Voigt, Fall, 1998

The Costs of Vertical Integration

Differences between stages in optimal scale of operation

Managing strategically different businesses

Agency costs

Higher capital investment

Reduced Flexibility • in responding to demand uncertainty

• in responding to changes in technology, customer preferences, etc.

Foreclose access to outside information/technology

Dulled incentives

Costs of bureaucratic hierarchy



Voigt, Fall, 1998

Benefits of the Market

Informational efficiencies i.e. price mechanisms and decentralized decision-making

Powerful incentive mechanisms i.e. better alignment self-interested behavior and incentives

Source: Collis and Montgomery, Corporate Strategy, 1997

e.g. Direct production costs of individual proprietors transacting with one another on the market will be lower than those involving employees inside a corporate hierarchy.


Voigt, Fall, 1998

Costs of the Market: Transaction Costs and Market Failures

Market relationships fail when they are subject to:• Opportunism (lying, cheating, stealing, acting self-interestedly)

• Asset specificity (small numbers) (Location specificity, physical asset specificity, and human asset specificity)

• Uncertainty (inability to predetermine all future eventualities)

• High Frequency (repeated exposure to hold up)

It is the possibility of firms acting opportunistically that causes market failure. The other three conditions create the opportunity for a firm to act opportunistically.

• Other Sources include resource inseparability, information impactedness, and market power



Voigt, Fall, 1998

The Choice between Market and Hierarchy

BENEFITS

COSTS

MARKET HIERARCHY

Informational Efficiencies

High-Powered Incentives

Transaction Costs

Market Power

Authority

Coordination

Bureaucracy

Agency theory



Voigt, Fall, 1998

How many firms are there in the The fewer the companies, the greater vertically related activity? the attraction of VI.

Do transactions-specific investments The greater the requirements for need to be made by either party? specific investments, the more

attractive is VI.

Does limited availability of information The greater the difficulty of specifying provide opportunities to the contracting and monitoring contracts, the greater firm to behave opportunistically (i.e., the advantages of VI. cheat)?

Are market transactions subject to taxes VI is attractive if it can circumvent and regulations? taxes and regulations.

How much uncertainty exists with regard Uncertainty raises the costs of writing to the circumstances prevailing over the and monitoring contracts, and period of the contracts? provides opportunities for cheating,

therefore increasing the attractiveness of VI.


Factors that are important in determining the merits of vertical integration compared to market transactions


Voigt, Fall, 1998

How uncertain is market demand? The greater the demand uncertainty--the more costly is VI.

Are the two stages similar in terms of The greater the dissimilarity in scale-the optimal scale of operations? the more difficult is VI.

How strategically similar are the differentThe greater the strategic dissimilarity stages in terms of key success factors the more difficult is VI. and the resources and capabilities required for success?

Does VI increase risk through requiring The heavier the investment heavy investments in multiple stages requirements and the greater the and compounding otherwise independent risks at each stage --the independent risk factors? more risky is VI.


Factors that are important in determining the merits of vertical integration compared to market transactions


Voigt, Fall, 1998

Intermediate Forms of Organization: A Continuum of Governance Arrangements

SPOTMARKET

INTERNAL HIERARCHY(full integration)

RANGE OF INTERMEDIATE FORMS

LONG-TERM CONTRACTS

STRATEGIC ALLIANCES

JOINT VENTURES

QUASI-VERTICAL INTEGRATION (PARTIAL OWNERSHIP)

Intermediate relationships may combine the benefits of both market transactions and internalization


Voigt, Fall, 1998

Spot sales/ purchases

Long-term contracts

Agency agreements

Franchises

Vertical integration

Joint ventures

Informal supplier/ customer

relationshipsSupplier/ customer

partnerships

Low Degree of Commitment High

Low

High

Fo

rmal

izat

ion

Different Types of Vertical Relationships



Voigt, Fall, 1998

Designing Vertical Relationships: Long-Term Contracts and Quasi-Vertical Integration

Intermediate between spot transactions and vertical integration are several types of vertical relationships --such relationships may combine benefits of both market transactions and internalization

Key issues in designing vertical relationships -- How is risk allocated between the parties? -- Are the incentives appropriate?



Voigt, Fall, 1998

Recent Trends in Vertical Relationships (US)

From competitive contracting to supplier partnerships (e.g. auto industry).

From vertical integration to outsourcing (not just components, also IT, distribution, and administrative services).

Diffusion of franchising.

Technology partnerships (e.g. IBM-Apple; Canon-HP).

Inter-firm networks.

General conclusion: Boundaries between firms and markets becoming increasingly blurred.



Voigt, Fall, 1998

JAPANESE APPROACH

Extensive use of subcontracting

Mitigate opportunism via:• equity links• personnel links• long-term relationships• implicit contracts

Close coordination of suppliers and assemblers• product design• JIT delivery

Source: Mari Sakakibara, UCLA, 1997


Voigt, Fall, 1998

Flow Chart for Vertical Integration Decisions

INSIDE HIERARCHY

YES

YES

YES

TRADEOFF

YES

MARKET CONTRACT

RENT APPROPRIABILITY

HOLD-UP TRANSACTION

COSTS

INCENTIVES AGENCY COSTS

COORDINATION FIAT

NO NO


Voigt, Fall, 1998

Action Steps in Scope of Firm Decisions

Step 1: Disaggregate the Industry Value Chain

Step 2: Competitive Advantage– Do you have a competitive advantage in the performance of

the activity?

Step 3: Market Failure– Is there a clear market failure? Are the costs of market

governance extremely high? Can dominant firms exercise market power?

Step 4: Need for Coordination– Is there an ongoing need for intensive coordination? Are

continual and integrated changes required? Is there a distinct interface between activities?



Voigt, Fall, 1998

Action Steps (cont’d)

Step 5: Importance of Incentives– How high are agency costs inside the hierarchy? How

much do worker skill and effort affect outcomes? Can an effective incentive scheme be designed? Which is more important: coordination or high-powered incentives?



Voigt, Fall, 1998

(1) In determining whether activities should be internal or external:

Summary: Creating Value in Vertical Activities

(2) In coordinating these activities along the value chain:

ExternalCustomer

Internal ActivitiesExternal Supplier

Be Better Than Competitors


Voigt, Fall, 1998

Ross Perot to GM Management:

“You don’t need to own a dairy to buy milk.”

General Conclusion

vertical scope of the firm what are the appropriate (efficient) organizational boundaries of the...

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