MKT 450 Strategic Management Mishari Alnahedh

LECTURE 8: VERTICAL INTEGRATION

Three Dimensions of Scope are: The Scope of the Firm Mishari Alnahedh Business Strategy is concerned with how a firm competes within a particular market. Corporate Strategy is concerned with where a firm competes, i.e. the scope of its activities Three Dimensions of Scope are: Vertical Scope Geographical Scope Product Scope © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Gaining Synergies via Vertical Integration Mishari Alnahedh Make vs. Buy The number of stages in a product’s or service’s value chain that a particular firm engages in defines that firm’s level of vertical integration. Forward integration: When Coca-Cola began buying its previously franchised independent bottlers. Backward integration: When Home Box Office began producing its own movies for screening on the HBO Cable Channel.

Understanding the Value Chain Mishari Alnahedh Raw Materials Backward Integration Diversification Manufacturing Forward Integration Distribution

Market Power Efficiency Why Vertically Integrate ? Entry Barriers Mishari Alnahedh Market Power Entry Barriers Downstream Price Maintenance Upstream Power Over Price Efficiency Specialized Assets & the Holdup Problem Protecting Product Quality Improved Scheduling

Costs and Benefits of Vertical Integration Mishari Alnahedh Changing ideas about the efficiency of large corporations as organizers of economic activity have exerted a strong influence on firms’ vertical integration strategies Thirty years ago, the dominant belief was that vertical integration offered superior coordination as well as protection from the vagaries of the market The prevailing wisdom today is that any benefits of vertical integration tend to be outweighed by the greater advantages of specializing in a narrow range of vertical activities

Market Economy vs. Corporate Economy Mishari Alnahedh What led to the firm becoming the more efficient organizing device? Technology: telegraph, telephone, and computer Management theories and methods Over time, the administrative costs of the firm has dropped, as compared with the transaction costs of markets

The Proportion of Total Output Contributed by the Largest Companies Mishari Alnahedh

Vertical Scope Product Scope Geographic Scope The Scope of the Firm’s Activities Mishari Alnahedh Vertical Scope What range of vertically linked activities should the firm encompass? Product Scope How specialized should the firm be in terms of the range of products it supplies? Geographic Scope What is the optimal geographical spread of activities for the firm?

Market Mechanism vs. Administrative Mechanism Mishari Alnahedh Verticall Scope Product Scope Geographical Scope [A] Single Integrated Firm V1 V2 V3 P1 P2 P3 C1 C2 C3 [B] Several Specialized Firms Linked by Markets V1 P1 P2 P3 C1 C2 C3 V2 V3 In situation [A] businesses 1, 2 & 3 are integrated within a single firm. In situation [B] businesses 1, 2 & 3 are independent firms linked by markets. Which situation is more efficient? —Depends upon whether the administrative costs of the integrated firm are less than the transaction costs of markets? © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Which is more efficient? Sources of Transaction Costs Mishari Alnahedh Which is more efficient? Several specialist firms linked by market contracts Several specialist firms linked by employment contracts, under common ownership Costs associated with market contracts Search costs involving purchasing and sales; negotiation and contract drawing costs; monitoring costs; enforcement costs of arbitration or litigation Costs associated with employment contracts Administrative costs of organizing within firms for optimal scale of operation, distinctive capabilities, high-powered incentives

Example: CHICKEN RUN Mishari Alnahedh Tyson Foods has made vertical integration work in the chicken business -- and helped make the poultry into the nation's most popular meat. In addition to the steps outlined below, a Tyson-owned feed mill produces 16 million pounds weekly to feed chickens at every stage up to slaughter 1. Tyson-Owned Breeding Stock 2. 16 Contract Pullet Farms: Young hens raised to 20 weeks of age 3. 42 Contract Egg-Laying Farms: Hens begin laying eggs at 26 weeks 4. Tyson-Owned Hatchery in Stillwell, Okla. Eggs hatch in 21 days 5. 148 Contract Chicken Farmers: Chicken reach slaughter weight in 51 days 6. Noel, Mo., Processing Plant: Processes 1.25 million chickens weekly Source: Tyson Foods

The Shifting Boundary Between Firms and Markets Mishari Alnahedh Time Period Main Trend Factors Changing the Relative Efficiency of Firms and Markets 1800-1975 Expanding the scale and scope of firms Administrative costs of firms fall due to: Advancing technology in transport, communication, and IT Advances in management—accounting systems, scientific management, organizational innovations 1976-1995 Biggest firms downsize: outsourcing; refocusing on core business More turbulent external environment increases administrative costs of big firms. New digital technologies available to small firms and individuals as well as big corporations 1996-2007 Global consolidation of many industries: (e.g. steel, oil, beer, banking) Globalization of markets Big corporations more effective at reconciling complexity with responsiveness © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Benefits of VI The Costs and Benefits of Vertical Integration Mishari Alnahedh Benefits of VI Technical economies from integrating processes e.g. iron and steel production But doesn’t necessarily require common ownership Avoids transactions costs of market contracts in situations where there are: Small numbers of firms Transaction-specific investments Opportunism and strategic misrepresentation Taxes and regulations on market transactions Superior Coordination © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Costs of VI The Costs and Benefits of Vertical Integration Mishari Alnahedh Costs of VI Differences in optimal scale of operation between different stages of production: prevents balanced vertical integration Inhibits development of distinctive capabilities Difficulties of managing strategically different businesses Incentive problems: lack of “high-powered” incentives Limits flexibility: In responding to demand fluctuations In responding to changes in technology, customer preferences, etc. Compounding of risk © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Vertical Integration vs. Outsourcing Mishari Alnahedh How many firms are available to transact with? The few the companies, the more attractive is VI Is transaction-specific investment needed? If yes, VI more attractive Does limited information permit cheating? VI can limit opportunism Are taxes or regulation imposed on transactions? VI can avoid them Are future market conditions uncertain? Uncertainty favors VI Do the different stages have similar optimal stages of operation? Greater the similarity, the more attractive is VI Are the two stages strategically similar? Strategic similarity favors VI Is entrepreneurial initiative required? If so, VI may blunt high-powered profit incentives How uncertain is market demand? Greater the unpredictability – the more costly VI Are risks compounded by linkages between vertical stages? VI increases risk © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Steel strip production Canning of food, drink, oil, etc. The Value Chain for Steel Cans Mishari Alnahedh Iron Ore Mining Steel production Steel strip production Can making Canning of food, drink, oil, etc. VERTICAL INTEGRATION VERTICAL INTEGRATION AND MARKET CONTRACTS MARKET CONTRACTS MARKET CONTRACTS What factors explain why some stages are vertically integrated, while others are linked by market transactions? © 2013 Robert M. Grant www.contemporarystrategyanalysis.com

Be Better Than Competitors Summary: Creating Value in Vertical Activities Mishari Alnahedh Be Better Than Competitors (1) In determining whether activities should be internal or external (2) In coordinating these activities along the value chain Vertical Scope of the Firm 20 Voigt; Fall 1998

Today’s Main Takeaway - Conclusion Mishari Alnahedh How to identify the relative efficiencies of firms and markets in organizing economic activity and apply the principles of transaction cost economics to determine the boundaries of firms How to assess the relative merits of vertical integration and market transactions in organizing vertically related activities and understand the circumstances that influence their comparative advantages Identify a range of possible relationships among vertically related firms, including spot market transactions, long-term contracts, franchise agreements, and alliances