1 Business Economics I Specific Assets and Relations with Suppliers

2 Plan of the topic 1. Introduction 2. Make or Buy? 3. The Value chain/The Vertical chain 4. Vertical Integration 5. Outsourcing 6. Specific Assets 7. Problems related to Specific Assets 8. Relations with Suppliers 9. Relations with Employees

3 Introduction Zara vs. Benetton Apple vs. Dell Does Pans & Company own the potato farms that supply it with potatoes? Does Danone own the cattle farms that supply it with milk? Make or buy - a trivial decision?

4 Make or Buy I? What are the advantages buying (i.e., contracting an exchange in the market) a component/raw material/intermediate product; ? Hint – when are you more specialized: when you produce everything you need to make your final product or when you buy some parts externally? What are the problems that are associated with buying in the market? General Motors and Fisher

5 The Value Chain/The Vertical Chain A value/vertical chain consists in the sequence of steps from acquisition of the raw materials to the delivery of the products to customers. Raw Materials Intermediate Products Production of Final Products Distribution and Sales After Sales Services Chemicals, rubber, minerals Plastics, electronic parts Computers Transport and Sales in FNAC Guarantee and Repair Service

6 Vertical Integration I Vertical Integration: the integration in one company of more steps of the value/vertical chain. Example: Zara is more vertically integrated than Benetton Upstream/Backward Integration – when we integrate activities towards raw materialsraw materials Example: General Motors buying Fisher Downstream/Forward Integration – when we integrate activities towards the final consumerfinal consumer Example: If Fisher had bought GM

7 Vertical Integration II Apple is more integrated than Dell IBM is more upstream/backward integrated than Dell Dell is more downstream/forward integrated than IBM However, it is often difficult to compare the degree of vertical integration of two firms. Usually we can say that one firm tends to integrate more or less Aside: Horizontal Integration: merger of two firms in the same step of the value/vertical chain (i.e., in the same industry) Example: JP Morgan Chase merged with BankOne

8 Outsourcing Outsourcing: the opposite of vertical integration. The firm reduces it integration by acquiring the components/services from previous or following steps in the value chain from the market or from other companies. How? Market Franchises Alliances Joint Ventures Examples: Dell buys the intermediate products (chips, processors, towers, OS) Benetton has franchising contracts for the distribution. It also outsourcers the manufacturing Why would you outsource? Focus on core competencies; i.e., enjoy advantages of specialization THEN, WHY DO FIRMS VERTICALLY INTEGRATE???

9 Advantages of Vertical Integration 1.Avoid the monopoly of another firm (electricity) 2.Extension of one’s own monopoly (Microsoft) 3.Price discrimination (if there are uses of your product with different value of your product) 4.Taxes and Regulations (truck drivers – employees or self-employed?) 5.Reducing Transaction Costs Where do TC come from? Where do TC come from?

10 Specific Assets I Why are we often afraid of falling in love? What happened to Vivendi in Lebanon (Beirut)? What happened to Yukos oil?

11 Specific Assets II Specific asset: we say that an asset is specific if its value will be significantly lower if used outside the current contractual relationship (alternative use or by another firm). Examples: Are the Pentium processors specific to Dell? Are the pipelines transporting the Russian gas specific to Gazprom?

12 Specific Assets III In other words, the value of the asset depends on the continuation of the contractual relationship.contractual relationship What does this imply when opportunism and information problems are present? Threat of expropriation Examples: Vivendi Telecommunication network in Africa – why no fixed phones and skyrocketing mobile phone market?

13 The Specific Assets’ Problem I Ex ante competition Usually there is competition before contracting. For example; The Beirut municipality asked several utility companies to make offers. Ex post monopoly However, after contracting and investing, there is partial or complete monopoly. Could Vivendi use the pipelines and the drainage system already laid down in Beirut at another location?

14 The Specific Assets’ Problem II Bi-lateral monopoly Often both parties have made specific investment and they can expropriate each other Example: petroleum producers and pipelines The only way for transportation of the oil is the pipeline The only use of the pipeline is to transport the oil from this location The pipeline operator can claim very high maintenance costs and the oil company can claim lower sales/prices

15 The Specific Assets’ Problem III What can happen if such a problem exists? Lower volume of trade: you might not agree to build the water supply network. Underinvestment: you will try to make your asset less specific or you will invest less. What would you do if you faced such a case? Vertically Integrate (however, lower specialization) Long term contracts (safeguards, TC in general) Buy in the market (implies low specificity)

16 Types of specific assets Geographical specificity Power plants close to coal mines or major customers Physical specificity Moulds for car bodies; firms’ signs and logos Human capital specificity Knowledge about how the firm works, clients, etc. Dedicated assets Extra capacity added to serve a particular client Co-specific assets: teamwork

17 Relations with Suppliers I The firm can choose between market, vertical integration, and long term contracts. What determines the choice: The degree of specificity of the asset The more specific the asset, the less likely to contract it externally - appropriabilityappropriability Think of transferabilitytransferability The degree of uncertainty of the environment

18 Relations with Suppliers II

19 Relations with Suppliers II Should Microsoft outsource the production of video games it sell for its X-Box?X-Box Should EasyJet outsource the catering service?service And AirFrance? Should we outsource defence (Why did the Arabs came to the Iberian peninsula in 8 th century; and the Turks to the Balkans?)defence Should we outsource being a parent, a spouse?

20 Relations with Employees/Employers Labour relations also can be viewed from the perspective of specific assets. Why do pilots and air-traffic controllers go on strike just before holidays start? What happens if you acquire skill that can be used just for this job in this firm? And if you have bought home nearby the place you work?

21 Appropriability The degree of specificity of the asset with respect to the relation depends on the share of the asset value each party can appropriate. We face a problem only if the party that can appropriate the value is not the party that owns the asset Example: printing press case

22 Transferability If an asset can be exchanged (transferred), we can alleviate the specific assets problem by transferring it to the party that can affect its value (i.e., vertical integration). If an asset can not be transferred (e.g., human capital), we can not solve the problem via vertical integration.