Chapter 3 - The Vertical Boundaries of the Firm

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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



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



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.



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.



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



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



Make-or-Buy Continuum



Vertical Chain of Production



Support Services

Accounting

Finance

Legal Support

Marketing

Planning

Human Resource Management



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).



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



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



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



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



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



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.



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



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



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



Economies of Scale

Production Costs and the Make-or-Buy Decision



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



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.



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



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



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



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.



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.



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



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.



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



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



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



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



Incomplete Contracts

Incomplete contracts involve someambiguities

They do not anticipate all possiblecontingencies

They do not spell out rights and

responsibilities of parties completely



Factors that Prevent Complete Contracting

Bounded rationality

Difficulties in specifying/measuring

performance Asymmetric information



Bounded Rationality

Individuals have limited capacity to

process information

deal with complexitypursue rational aims

Individuals cannot foresee all possible

contingencies



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.



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.



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.



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



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)



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



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.



Design Attributes

If coordination is critical, administrationcontrol may replace the market mechanism

Design attributes may be moved in-house



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.



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



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



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).



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)



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



Forms of Asset Specificity

Relation-specific assets may exhibitdifferent forms of specificity

Site specificityPhysical asset specificity

Dedicated assets

Human asset specificity



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



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



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



d l f i



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



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




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




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



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



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



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



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



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



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



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



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



The Make-or-Buy Decision Tree

Documents

Chapter 3 - The Vertical Boundaries of the Firm