vertical scope
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Vertical ScopeTRANSCRIPT
VERT SCOPEVertical Scope of the Firm
What are the appropriate (efficient) organizational boundaries of the firm?
1
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
VERTICAL PRODUCT GEOGRAPHICAL AREAS
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
Vertical Scope of the Firm * Voigt, Fall, 1998
Defining Vertical Integration
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)
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
Benefits of Vertical Integration
Economies of combined operations
Assure supply or demand
Protect proprietary technology
Gain (or offset) market power
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
The Costs of Vertical Integration
Differences between stages in optimal scale of operation
Managing strategically different businesses
in responding to changes in technology, customer preferences, etc.
Foreclose access to outside information/technology
Dulled incentives
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
Benefits of the Market
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.
Vertical Scope of the Firm * Voigt, Fall, 1998
Costs of the Market:
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
Source: Collis and Montgomery, Corporate Strategy, 1997
Vertical Scope of the Firm * Voigt, Fall, 1998
The Choice between Market and Hierarchy
BENEFITS
COSTS
MARKET
HIERARCHY
Vertical Scope of the Firm * Voigt, Fall, 1998
Factors that are important in determining the merits of vertical integration compared to market transactions
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.
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
Factors that are important in determining the merits of vertical integration compared to market transactions
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 different The 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.
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
Intermediate Forms of Organization: A Continuum of Governance Arrangements
SPOT
MARKET
Intermediate relationships may combine the benefits of both market transactions and internalization
Vertical Scope of the Firm * Voigt, Fall, 1998
Spot sales/ purchases
Low
High
Formalization
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * 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
-- How is risk allocated between the parties?
-- Are the incentives appropriate?
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
Recent Trends in
Vertical Relationships (US)
(e.g. auto industry).
(not just components, also IT, distribution, and administrative services).
Diffusion of franchising.
Inter-firm networks.
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
JAPANESE APPROACH
product design
JIT delivery
Vertical Scope of the Firm * Voigt, Fall, 1998
Flow Chart for Vertical Integration Decisions
INSIDE HIERARCHY
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?
Source: Collis and Montgomery, Corporate Strategy, 1997
Vertical Scope of the Firm * 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?
Source: Collis and Montgomery, Corporate Strategy, 1997
Vertical Scope of the Firm * 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:
External
Customer
Ross Perot to GM Management:
“You don’t need to own a dairy to buy milk.”
General Conclusion
What are the appropriate (efficient) organizational boundaries of the firm?
1
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
VERTICAL PRODUCT GEOGRAPHICAL AREAS
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
Vertical Scope of the Firm * Voigt, Fall, 1998
Defining Vertical Integration
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)
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
Benefits of Vertical Integration
Economies of combined operations
Assure supply or demand
Protect proprietary technology
Gain (or offset) market power
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
The Costs of Vertical Integration
Differences between stages in optimal scale of operation
Managing strategically different businesses
in responding to changes in technology, customer preferences, etc.
Foreclose access to outside information/technology
Dulled incentives
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
Benefits of the Market
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.
Vertical Scope of the Firm * Voigt, Fall, 1998
Costs of the Market:
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
Source: Collis and Montgomery, Corporate Strategy, 1997
Vertical Scope of the Firm * Voigt, Fall, 1998
The Choice between Market and Hierarchy
BENEFITS
COSTS
MARKET
HIERARCHY
Vertical Scope of the Firm * Voigt, Fall, 1998
Factors that are important in determining the merits of vertical integration compared to market transactions
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.
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
Factors that are important in determining the merits of vertical integration compared to market transactions
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 different The 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.
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
Intermediate Forms of Organization: A Continuum of Governance Arrangements
SPOT
MARKET
Intermediate relationships may combine the benefits of both market transactions and internalization
Vertical Scope of the Firm * Voigt, Fall, 1998
Spot sales/ purchases
Low
High
Formalization
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * 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
-- How is risk allocated between the parties?
-- Are the incentives appropriate?
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
Recent Trends in
Vertical Relationships (US)
(e.g. auto industry).
(not just components, also IT, distribution, and administrative services).
Diffusion of franchising.
Inter-firm networks.
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
Vertical Scope of the Firm * Voigt, Fall, 1998
JAPANESE APPROACH
product design
JIT delivery
Vertical Scope of the Firm * Voigt, Fall, 1998
Flow Chart for Vertical Integration Decisions
INSIDE HIERARCHY
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?
Source: Collis and Montgomery, Corporate Strategy, 1997
Vertical Scope of the Firm * 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?
Source: Collis and Montgomery, Corporate Strategy, 1997
Vertical Scope of the Firm * 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:
External
Customer
Ross Perot to GM Management:
“You don’t need to own a dairy to buy milk.”
General Conclusion