Vertical Chain
Vertical Integration
The degree to which the firm controls the chain.
Vertical Integration
Upstream Integration – towards raw materials
Vertical Integration
Downstream Integration – towards end customer
Boundaries of the Firm
The question for a firm is “Where to draw the boundary.” The answer is closely tied to material in CH 3.
Expanding is integrating
Contracting is outsourcing
Outsourcing• South Park – “They took our jobs”
http://www.gofish.com/userVideoPlayer.gfp?gfid=30-1015163
• Dell expanding in India - http://www.nytimes.com/2006/03/21/technology/21dell.html?adxnnl=1&adxnnlx=1143497181-q6B42De9MThtS0g2ZNxwqA
• The Dubai Ports deal. http://www.cnn.com/2006/POLITICS/03/09/port.security/
• A guide to best practice by Accenture: http://www.accenture.com/xdoc/en/services/outsourcing/ps/global/landing_ps.pdf
Should a firm vertically integrate?
Pros of doing it in-houseAvoid double markup problem
Upstream Firm: MC=10 and No Fixed CostDownstream Firm: P= 110-Q, MR=110-2Q Only cost to D is price set by U
Double Mark Up Problem
$/q
q
MCU
PD
MRD
What will MC to D look like?
Given a price set by U, what quantity will D buy?
Double Mark Up Problem
$/q
q
MCU
PD
MRD=PUMRU
So MRD=PU
MRU=110-4Q
What quantity will be traded?
How much will each firm earn?
Double Mark Up Problem
$/q
q
MCU
PD
MRD=PUMRU
PD = 85
PU = 60
QD =25
Profits U: 50x25=1250
Profits D: 25x25= 625
Double Mark Up Problem
$/q
q
MC
P
MR
Q =50
P = 60
with Vertical Integration
Profits: 50x50 = 2500
&
Consumer Surplus Increased
Other ways to Avoid Double Mark-up
Resale Price Maintenance: Up stream firm sets price that downstream firm can charge.
Manufactures Suggested Retail Price (MSRP).
Two-part Tariff
Should a firm vertically integrate?
Pros of doing it in-houseNo Hold Up Problem
ex: U invests ($5M) in equipment and training to produce component (MC= $1) specific to D.
The investment becomes a sunk cost for U.D could offer only $2 on 1M units. U would take it as it increases profits, but overall U earns a loss.
Therefore, U is hesitant of undertaking this investment.
Should a firm vertically integrate?
Pros of doing it in-houseMinimize Supply DisruptionsReduced ExternalitiesMonitoring QualityLower Contracting and Transaction CostsTaxes and RegulationCentralized Decision Making
Should a firm vertically integrate?
Pros of outsourcingFlexibleEconomies of ScaleSpecialized KnowledgeDecentralized Decision MakingFocus on Core Competencies
Integration vs Outsourcingchoosing along a continuum
Asset specificity, uncertainty, and the procurement decision
Other Vertical Relationships
Hybrid ArrangementsStrategic AlliancesLong Term ContractingJoint Ventures