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8/9/2019 3rdchap13ppt4924.Ppt the Scope of a Firm
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Vertical Integration and
The Scope of the Firm
Vertical Integration and
The Scope of the Firm
Transactions Costs and the Scope of the Firm
--Why does the firm exist?
--The trend over time The Costs and Benefits of Vertical Integration
Designing Vertical Relationships: Long-term
Contracts and Quasi-Vertical Integration
Recent Trends
OUTLINE
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From Business Strategy to Corporate
Strategy: The Scope of the Firm
From Business Strategy to Corporate
Strategy: The Scope of the Firm
Business Strategyis concerned with howa firm
computes within a particular market Corporate Strategyis concerned with where a
firm competes the scope of its activities
The dimensions of scope are
geographical scope
vertical scope
product scope
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Transactions Costs and the
Scope of the Firm
Transactions Costs and the
Scope of the Firm
Which is more efficient : several specialist firms linked by markets, or
the combination of these specialist firms under common
ownership.
VERTICAL PRODUCT GEOGRAPHICAL
AREAS
SINGLE V1 P1 P2 P3 A1 A2 A3
FIRM V2
V3
SEVERAL V1 P1 P2 P3 A1 A2 A3SPECIALIZED V2
FIRMS V3
Common Issue--- What are TRANSACTION COSTS of markets
compared with administrative costs of the firm?
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Transactions Costs and The Existence
of the Firm
Transactions Costs and The Existence
of the Firm
Transaction cost theory explains not just the boundaries of
firms, also the existence of firms.
In 18th century English woolen industry, no firms --
independent spinners, weavers, and merchants. Residential remodeling industry -- mainly independent self-
employed builders, plumbers, electricians, painters.
Key issue -- transaction costs of the market vs.
administrative costs of firms.
Note: transaction costs = cost of locating, negotiating, and
enforcing a contract.
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Changes in Aggregate
Concentration Over Time
Changes in Aggregate
Concentration Over Time
Since early 19th century, firms have grown in size
Alfred Chandler points to growing vertical, geographical and product
scope of industrial companies
What factors explain this trend?
Why has the trend reversed since the late 1970s?
1930 1940 1950 1960 1970 1980 1990
50%
20%
35%
Salesof10 0
biggestcos.as%
ofUSin
dus
trialoutput
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Determinants of Changes
in Corporate Scope
Determinants of Changes
in Corporate Scope
1800 - 1975: Expansion in size & scope of biggest industrial corporations.Administrative costs of firms fell due to Advances in transportation, information and communication
technologies Advances in management - accounting systems, decision sciences,
financial techniques, organizational innovations, scientific management
1975 - 1995: Contraction in size & scope of biggest industrialcorporations. Increased market turbulence, more competition,
accelerated technological change
Need for speed, flexibility, responsiveness
Large, complex corporations become relatively less efficient
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The Costs and Benefits of Vertical
Integration: BENEFITS
The Costs and Benefits of Vertical
Integration: BENEFITS
Technical economies from integrating processes e.g. iron
and steel production
-- but doesnt necessarily require common ownership Superior coordination
Avoids transactions costs of market contracts from:
-- small numbers of firms
-- transaction-specific investments
-- opportunism and strategic misrepresentation
-- taxes and regulations on market transactions
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The Costs and Benefits of Vertical
Integration: COSTS
The Costs and Benefits of Vertical
Integration: COSTS
Differences in optimal scale of operation between different
stages prevents balanced VI
Strategic differences between different vertical stages creates
management difficulties Inhibits development of and exploitation of core
competencies
Limits flexibility -- in responding to demand cycles
-- in responding to changes in technology,
customer preferences, etc.(But VI may be conducive to system-wide flexibility)
Compounding of risk
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When is Vertical Integration More Attractive
than Outsourcing?
How many firms are available The fewer the companies
to undertake the activities? the more attractive is VI
Is transaction-specific investment If yes, VI more attractive needed?
Does limited information permit VI can limit opportunism cheating?
Are taxes or regulation imposed VI can avoid them on
transactions?
Do the two stages have similar Greater the similarity, the optimal
scale of operation? more attractive is VI
Are the two stages strategically Greater the strategic
similar? similarity ---the more attractive is VI
How uncertain is market demand? Greater the unpredictability ----the more
costly is VI
Does VI increase risk? If heavy investment required and risks
between stages are inter- related----VI increases risk.
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Designing Vertical Relationships: Long-
Term Contracts and Quasi-Vertical
Integration
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?
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Recent Trends in Vertical RelationshipsRecent Trends in Vertical Relationships
From competitive contractingto supplier partnerships, e.g.
in autos
From vertical integration to outsourcing (not just
components, also IT, distribution, and administrativeservices).
Diffusion of franchising
Technology partnerships (e.g. IBM- Apple; Canon- HP)
Inter-firm networks
General conclusion:- boundaries between firms and
markets becoming increasingly blurred.
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Different Types of Vertical
Relationship
Different Types of Vertical
Relationship
Spot sales/
purchases
Long-term
contracts
Agencyagreements
Franchises
Vertical
integration
Joint
ventures
Informal
supplier/
customer
relationships Supplier/
customer
partnerships
Low Degree of Commitment High
Low
High
Forma
liza
tion