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Economics of Strategy
Fifth Edition
Slides by: Richard Ponarul, California State University, Chico
Copyright 2010 John Wiley Sons, Inc.
Chapter 5
The Vertical Boundaries of the Firm
Besanko, Dranove, Shanley and Schaefer
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The Vertical Chain
The vertical chain
begins with the acquisition of raw
materials andends with the sale of finished
goods/services.
Organizing the vertical chain is animportant part of business strategy
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The Vertical Chain
Vertically integrated firms (Scott Paper)perform all the tasks in the vertical chain in-house.
Vertically disintegrated firms (Nike)outsource most of the vertical chain tasks.
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Vertical Boundaries of the Firm
Vertical boundaries of the firm demarcate which tasks in the vertical chain are to be
performed inside the firm and which to beout-sourced.
The choice is between the market and the
organization is a make or buy decision.
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Make versus Buy
There is a continuum of possibilities between the two extremes
Arms length transactionsLong term contracts
Strategic alliances and joint ventures
Parent/subsidiary relationship
Activity performed internally
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Upstream, Downstream
Early steps in the production process areupstream (Timber for furniture)
Later steps are downstream (finished goodsin showrooms)
Support services are provided all along the
chain
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Make-or-Buy Continuum
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Vertical Chain of Production
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Support Services
Accounting
Finance
Legal Support
Marketing
Planning
Human Resource Management
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Defining Boundaries
Firms need to define their vertical boundaries.
Outside specialists who can perform verticalchain tasks are market firms.
Market firms are often recognized leaders in
their field (Example: UPS).
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Market Firms
Benefits of using market firmsEconomies of scale achieved by market firms
Value of market discipline
CostsProblems in coordination of production flows
Possible leak of private information
Transactions costs
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Some Make-or-Buy Fallacies
Firm should make rather than buy assets thatprovide competitive advantages
Outsourcing an activity eliminates the cost of that
activity Making instead of buying captures the profit
margin of the market firms
Vertical integration insures against the risk of highinput prices
Making ties up the distribution channel and deniesaccess to the rivals
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Make-or-Buy & Competitive Advantage
A firm may believe that a particular asset is asource of competitive advantage
But if the asset is easily available in themarket the belief regarding competitiveadvantage will have to be reevaluated
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Outsourcing and Cost
It should not matter if the costs ofperforming an activity are incurred by the
firm (Make) or by the supplier (Buy) The relevant consideration is whether it is
more efficient to make or to buy
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Vertical Integration and Profits
The supplier’s profit margin may notrepresent any economic profit, and profit
margin should “pay” for the capitalinvestment and the risk borne
If the supplier is earning economic profit, isthere a reason for its persistence?
Market competition should eventually erodeaway any economic profit
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Vertical Integration & Input Price Risk
Instead of vertical integration, long termcontracts can be used to reduce input pricerisk
Forward or futures contracts can also beused to hedge input price risk
Alternately the capital tied up in verticalintegration could be used as a contingencyfund to deal with price fluctuations.
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Foreclosure of Distribution Channels
Acquiring a downstream monopoly suppliermay seem to be a way to tie up channels andincrease profits
Three possible limitations
Possible violation of anti trust laws
Price paid for the downstream firm may reflectthe full value of the monopoly power
Competitors may be able to open newdistribution channels
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Foreclosure of Distribution Channels
Foreclosure can succeed if:
Upstream monopolist is unable to commit
to higher prices (discounting to more pricesensitive buyers)
Upstream firm is creating a network by
acquiring several downstream firms
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Reasons to Buy
Market firms may have patents orproprietary information that makes low cost
production possible Market firms can achieve economies of scale
that in-house units cannot
Market firms are likely to exploit learningeconomies
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Economies of Scale
Production Costs and the Make-or-Buy Decision
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Economies of Scale
A given manufacturer of automobiles needs A’ units
An outside supplier may reach the minimumefficient scale (A *) by supplying to differentautomobile manufacturers
The cost is lowered by using the outsidesupplier
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Economies of Scale
Minimum efficient scale may be feasible forthe independent supplier but not for an
automobile manufacturer. Automobile manufacturers would rather buy
anti-lock brakes from an independent
supplier than from a competitor.
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Economies of Scale
Will the outside supplier charge C* (itsaverage cost) or C’ (the average cost for the
manufacturer for in-house production)? The answer depends on the degree of
competition faced by the supplier
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Agency Costs
Agency costs are due to slacking byemployees and the administrative effort to
deter slacking. When there are joint costs measuring and
rewarding individual unit’s performance isdifficult.
It is difficult to internally replicate theincentives faced by market firms
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Agency Costs
It can be difficult to evaluate the efficiency when a task is performed by a “cost center” within an organization.
Inherent advantages enjoyed by the firm inthe market allows its managers to live withthe agency costs
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Influence Costs
Performing a task in-house will lead toinfluence costs.
Internal Capital Markets allocates scarcecapital within the firm
Allocations can be favorably affected by
influence activities Resources consumed by influence activities
represent influence costs.
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Influence Costs
In-house suppliers can use their influence with headquarters to shield againstpressures to become more competitive.
Large vertically integrated firms are moreprone to influence cost problems than smallindependent firms.
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Reasons to Make
Costs imposed by poor coordination
Reluctance of partners to develop and share
private information Transactions cost that can be avoided by
performing the task in-house
Each of the three problems can be traced todifficulties in contracting
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Role of Contracts
Firms often use contracts when certaintasks are performed outside the firm.
The contracts listthe set of tasks that need to be performed
and
the remedies if one party fails to fulfill itsobligation.
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Contracts
Contracts protect each party to atransaction from opportunistic
behavior of other(s)Contracts’ ability to provide this
protection depends on
the “completeness” of contracts
the body of contract law
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Complete Contract
A complete contract stipulates what eachparty should do for every possiblecontingency
No party can exploit others’ weaknesses To create a compete contract one should be
able to contemplate all possiblecontingencies
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Complete Contract (Cont.)
A complete contract maps each possiblecontingency to a set of stipulated actions
One should be able to define and measureperformance
The contract must be enforceable
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Complete Contract (Cont.)
To enforce a contract, an outside party(judge, arbitrator) should be able to
observe the contingencyobserve the actions by the parties
impose the stated penalties for non-performance
Real life contracts are usually incompletecontracts
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Incomplete Contracts
Incomplete contracts involve someambiguities
They do not anticipate all possiblecontingencies
They do not spell out rights and
responsibilities of parties completely
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Factors that Prevent Complete Contracting
Bounded rationality
Difficulties in specifying/measuring
performance Asymmetric information
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Bounded Rationality
Individuals have limited capacity to
process information
deal with complexitypursue rational aims
Individuals cannot foresee all possible
contingencies
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Specifying/Measuring Performance
What constitutes fulfillment of a contractmay have some residual vagueness.
Terms like “normal wear and tear” may havedifferent interpretations.
Performance cannot always be measured
unambiguously.
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Asymmetric Information
Parties to the contract may not have equalaccess to contract-relevant information.
The knowledgeable party can misrepresentinformation with impunity.
Contracting on items that rely on this
information is difficult.
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Contract Law
Contract law facilitates transactions whencontracts are incomplete.
Parties need not specify provisions that arecommon to a wide class of transactions.
In the U. S. contract law is embodied in
common law and the Uniform CommercialCode.
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Limitations of Contract Law
Doctrines of contract law are in broadlanguage that could be interpreted in
different ways Litigation can be a costly way to deal with breach of contract
Litigation can be time consumingLitigation weakens the business relationship
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Coordination of Production Flows
Firms make decisions that depend in part onthe decisions made by other firms along the vertical chain.
A good fit will have to be accomplished in alldimensions of production. (Examples:Timing, Size, Color and Sequence)
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Coordination Problems
Without good coordination, bottlenecksarise in the vertical chain
To ensure coordination, firms rely oncontracts
Firms also use merchant coordinators –
independent specialists who work with firmsalong the vertical chain
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Coordination Problems
Coordination is especially important whendesign attributes are present
Design attributes are attributes that need torelate to each other in a precise fashion.Some examples are:
Fit of auto sunroof glass to aperture
Timely delivery of a critical component
Small errors can be extremely costly.
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Design Attributes
If coordination is critical, administrationcontrol may replace the market mechanism
Design attributes may be moved in-house
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Leakage of Private Information
Firms do not want to compromise thesource of their competitive advantage .
Private information on product design orproduction know-how may be compromised when outside firms are used in the verticalchain.
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Leakage of Private Information
Well defined patents can help but may notprovide full protection
Contracts with non-compete clauses can beused to protect against leakage ofinformation
In practice, non-compete clauses can behard to enforce
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Transactions Costs
If the market mechanism improvesefficiency, why do so many of the activitiestake place outside the price system? (Coase)
Costs of using the market that are saved bycentralized direction – transactions costs
Outsourcing entails costs of negotiating, writing and enforcing contracts
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Transactions Costs
Costs incurred due to opportunistic behaviorof parties to the contract and efforts to
prevent such behavior are transaction costsas well.
Transactions costs explain why economicactivities occur outside the price system(inside the firm).
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Transactions Costs
Sources of transactions costs
Investments that need to be made in
relationship specific assetsPossible opportunistic behavior after the
investment is made (holdup problem)
Quasi-rents (magnitude of the holdupproblems)
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Relationship-Specific Assets
Relation-specific assets are assets essentialfor a given transaction
These assets cannot be redeployed foranother transaction without cost
Once the asset is in place, the other party tothe contract cannot be replaced without cost, because the parties are locked into therelationship to some degree
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Forms of Asset Specificity
Relation-specific assets may exhibitdifferent forms of specificity
Site specificityPhysical asset specificity
Dedicated assets
Human asset specificity
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Site Specificity
Assets may have to be located in closeproximity to economize on transportationcosts and inventory costs and to improve
process efficiencyCement factories are usually located near lime
stone deposits
Can-producing plants are located near can-fillingplants
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Physical Asset Specificity
Physical assets may have to be designedspecifically for the particular transaction
Molds for glass container production custom
made for a particular user
A refinery designed to process a particular gradeof bauxite ore
d d
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Dedicated Assets
Some investments are made to satisfy a single buyer, without whose business the investment will not be profitable.
Ports investing in assets to meet the specialneeds of some customers
A defense contractor’s investment in
manufacturing facility for making certainadvanced weapon systems
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d l f i
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Fundamental Transformation
Prior to the investment in relationship specificassets there are many trading partners.
Once the investment is made the situation becomes a bargaining situation with a smallnumber partners
Relationship specific assets cause a
fundamental transformation in the relationship
d Q i
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Rents and Quasi-Rents
The term rent denotes economic profits – profits after all the economic costs, includingthe cost of capital, are deducted
Quasi-rent is the excess economic profitfrom a transaction compared with economicprofits available from an alternate
transaction
R d Q i R
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Rents and Quasi-Rents
Firm A makes an investment to produce acomponent for Firm B after B as agreed to buy from A at a certain price
At that price A can earn an economic profitof π1
If B were to renege on the agreement and Ais forced to sell its output in the openmarket, the economic profit will be π2
R d Q i R
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Rents and Quasi-Rents
Rent is the minimum economic profitneeded to induce A to enter into this
agreement with B (π1) Quasi-rent is the economic profit in excess
on the minimum needed to retain A in theselling relationship with B (π
1
- π2
)
Th H ld P bl
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The Holdup Problem
Whenever π1 > π2, Firm B can benefit byholding up A and capturing the quasi-rent
for itself A complete contract will not permit the breach.
With incomplete contracts and relationship-specific assets, quasi-rent may exist and leadto the holdup problem
Eff t T ti C t
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Effect on Transactions Costs
The holdup problem raises the cost oftransacting exchanges
Contract negotiations become more difficult
Investments may have to be made to improve theex-post bargaining position
Potential holdup can cause distrust
There could be underinvestment in relationshipspecific assets
H ld d C t t N ti ti
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Holdup and Contract Negotiations
When there is potential for holdup, contractnegotiations become tedious as each partyattempts to build in protections for itself
Temptations on the part of either party toholdup can lead to frequent renegotiations
There could be costly disruptions in the
exchange
H ld d C tl S f d
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Holdup and Costly Safeguards
Potential for holdup may lead parties to investin wasteful protective measures
Manufacturer may acquire standby productionfacility for an input that is to be obtained from amarket firm
Floating power plants are used in place of
traditional power plants to avoid site specificinvestments
H ld d Di t t
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Holdup and Distrust
Potential holdups cause distrust betweenparties and raise the cost of transactions
Distrust can make contracting more costly sincecontracts will have to be more detailed
Distrust affects the flow of information needed toachieve process efficiencies
H ld d U d i t t
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Holdup and Underinvestment
When there is a holdup, the investmentmade in relationship-specific assets loses value
Anticipating holdups, firms will makeotherwise sub-optimal level of investmentsand suffer higher production costs
Th H ld P bl S
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The Holdup Problem: Summary
Relation-specific assets support a particulartransaction
Redeploying to other uses is costly
Quasi rents become available to one partyand there is incentive for a holdup
Potential for holdups lead toUnderinvestment in these assets Investment in safeguardsReduced trust
D bl M i li ti
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Double Marginalization
Vertical integration helps if both theupstream firm and the downstream firmhave market power
Upstream firm sets its price above marginalcost
Vertical integration increases output, lowers
the final price and increases the profits
Th M k B D i i T
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The Make-or-Buy Decision Tree