BA 950 Policy Formulation and Administration Lecture 7 Corporate Strategy: Vertical Integration, Diversification, and Strategic Alliances © Ram Mudambi, Temple University and University of Reading, 2006.

Outline Organizing the firm Transaction costs analysis Vertical integration - VI Types of VI Creating value through VI Vertical relationships and outsourcing Diversification Related and unrelated diversification Entering new markets © Ram Mudambi, Temple University and University of Reading, 2006.

The Value Chain Upstream Downstream © Ram Mudambi, Temple University and University of Reading, 2006.

The Boundaries of the Firm – 1 Organizational Form Markets ‘Invisible Hand’ – Adam Smith Hierarchies ‘Visible Hand’ – Alfred Chandler Spot Markets Contracts Vertical Integration © Ram Mudambi, Temple University and University of Reading, 2006.

Firm Organization – A simple view VALUE CHAIN STAGE 1 Upstream STAGE 2 Downstream Firm 1 Market transactions Firm 2 Intra-firm transactions © Ram Mudambi, Temple University and University of Reading, 2006.

Intermediate manufacturer Stages in the Raw-Material-to-Consumer Value Chain in the Personal Computer Industry IBM End user Distribution Assembly Intermediate manufacturer Raw materials Examples: Dow Chemical Union Carbide Kyocera Examples: Intel Seagate Micron Examples: Apple Compaq Dell Gateway Examples: Computer World Office Max Staples © Ram Mudambi, Temple University and University of Reading, 2006.

The Boundaries of the Firm – 2 Spot Markets When the buyer and seller of an input meet, exchange, and then go their separate ways Contracts A legal document that creates an extended relationship between a buyer and a seller Vertical Integration When a firm shuns other suppliers and chooses to produce an input internally Spot Exchange Specialization, avoids contracting costs, avoids costs of vertical integration. Possible “hold-up problem” Contracting Specialization, reduces opportunism, avoids skimping on specialized investments Costly in complex environments Vertical Integration Reduces opportunism, avoids contracting costs Lost specialization, organizational costs © Ram Mudambi, Temple University and University of Reading, 2006.

Transaction Costs – 1 The costs of using the market mechanism Coordination costs Process C & C (inventories, information) Costs based on asymmetric information Policing costs Bargaining costs Coordination costs C & C = command and control Asymmetric information Information differential between the two parties in the market transaction © Ram Mudambi, Temple University and University of Reading, 2006.

Asymmetric Information Transaction Costs – 2 Asymmetric Information Policing costs: Moral hazard & adverse selection Effort; Quality; Property rights; Restrictive agreements Bargaining costs Asset specificity and hold-up New products and processes Economies of scope Policing costs – principal-agent framework – more detailed example follows Moral hazard, adverse selection – e.g., problem in insurance markets – property, health Principal – upstream (e.g., franchiser); Agent – downstream (e.g., franchisee) Fixed payment  no monitoring required, more risk borne by franchisee Royalty  monitoring required, less risk borne by franchisee Monitoring of quality is required Restrictive practices – e.g., price discrimination – need to be monitored Bargaining costs Hold-up – includes sites (proximate location), physical and human assets Investment in new technology – differing perspectives of risks and returns by upstream and downstream firms Economies of scope – information, learning and other benefits that transfer across processes, both horizontal and vertical. The bargaining costs of transferring this across firm boundaries may be prohibitive. © Ram Mudambi, Temple University and University of Reading, 2006.

Optimal Firm Organization Spot Exchange No Substantial specialized investments relative to contracting costs? Complex contracting environment relative to costs of integration? Yes Contract No Vertical Integration Yes © Ram Mudambi, Temple University and University of Reading, 2006.

Vertical Integration: Forward, backward, full, partial PARTIAL INTEGRATION FULL INTEGRATION © Ram Mudambi, Temple University and University of Reading, 2006.

Vertical Integration Greater attraction of VI when Thin markets; TSAs necessary; Demand uncertainty Difficulty of monitoring/writing contracts  VI Limited information; Environmental uncertainty Taxes/regulations on market contracts VI to circumvent taxes/regulations VI difficult when Scale differential in stages; Strategic dissimilarities in resources/capabilities/success factors TSA = transaction specific asset © Ram Mudambi, Temple University and University of Reading, 2006.

Creating Value Through Vertical Integration Advantages of a vertical integration strategy: Builds entry barriers to new competitors by denying them inputs and customers. Facilitates investment in efficiency-enhancing assets that solve internal mutual dependence problems. Protects product quality through control of input quality and distribution and service of outputs. Improves internal scheduling (e.g., JIT inventory systems) responses to changes in demand. © Ram Mudambi, Temple University and University of Reading, 2006.

Creating Value Through Vertical Integration Disadvantages of vertical integration Cost disadvantages of internal supply purchasing. Remaining tied to obsolescent technology. Aligning input and output capacities with uncertainty in market demand is difficult for integrated companies. © Ram Mudambi, Temple University and University of Reading, 2006.

Bureaucratic Costs and the Limits of Vertical Integration The costs of running an organization rise with integration due to: The lack of an incentive for internal suppliers to reduce their operating costs. The lack of strategic flexibility in times of changing technology or uncertain demand. Bureaucratic costs reduce the value of vertical integration. © Ram Mudambi, Temple University and University of Reading, 2006.

Designing Vertical Relationships Low Degree of Commitment High Low Informal relationships Spot Markets VI Formal Partnerships Joint ventures Agency Long Term Contracts Franchises High © Ram Mudambi, Temple University and University of Reading, 2006.

Short-term contracts and competitive bidding Alternatives to Vertical Integration: Cooperative Relationships and Strategic Outsourcing Short-term contracts and competitive bidding Strong competitors attempt to control supplier costs with minimal-length contracts. Poor treatment of suppliers raises competitor input costs. Strategic alliances and long-term contracting Long-term contracts foster cooperative relationships. Alliances reduce the need for vertical integration. © Ram Mudambi, Temple University and University of Reading, 2006.

Building Long-Term Cooperative Relationships Discourage opportunism Maintain dynamic efficiency Hostage taking Both parties arrange to become mutually dependent on each other, fostering a cooperative relationship. A believable commitment to support the long-term relationship (a credible commitment). Maintaining market discipline requires: Periodic renegotiation of the contractual relationship. Developing a parallel sourcing policy with two suppliers for critical inputs. Hostage taking – firm 1 invests in specialized machinery, giving firm 2 a hostage. Firm 2 makes design adjustments making it unable to utilize inputs from another supplier. GM’s modular manufacturing at the Blue Macaw project in Brazil with supplier parks is an example. Suppliers invest in specialized machinery and location, and GM becomes dependent on them to maintain its low JIT inventory costs and modular manufacturing costs. Credible commitments(in the West) - signing a legally binding contract, granting designated source privileges, guaranteeing a minimum purchase order, etc. Credible commitments (in the East) – making a partnership commitment, e.g., in Japan. Breaking this damages the firm’s OTHER cooperative arrangements. © Ram Mudambi, Temple University and University of Reading, 2006.

Hostages – creating trust in one-shot games* Providing a hostage – Reduces the incentive for the trustee (hostage-giver) to abuse the trust Reduces the cost of trust abuse to the trustor (hostage-taker) Provides a signal of the trustee’s (hostage-giver) quality and intentions However – Ugly princess problems, etc. Historically, hostages have often been used to guarantee performance. The typical case was for an imperial authority or conquering power to take hostages from a village to guarantee the payment of taxes in the form of money or labor services. The Chinese used this technique as early as the fourth century BC (Dewey 1988). The Romans, the Mongols, and almost everyone else it seems also used hostage taking. Involuntary hostage taking offends our deepest sense of justice not only because it serves the interests of the conquerors, but also because it involves punishing the innocent. Indeed, a Geneva Convention has now outlawed the practice. A historically important variant of hostage taking is the use of the entire population of a village to guarantee the performance of each of its members. The typical method was to impose taxes on a village, rather than on a household. Then if someone runs away, the rest of the village has to make up their share of the tax. This forces the village to organize itself to prevent runaways. The result is that the entire village is held hostage for the performance of each of its members. In Russia this system was introduced by the Mongols, but flourished under the Czars long after their departure (Dewey 1988). One may plausibly speculate that the long experience of coercive village responsibility may have helped shape Russian popular attitudes against individualism. [Axelrod, Six advances in cooperation theory, Analyse & Kritk, 2000.] * Raub and Weesie (2000) © Ram Mudambi, Temple University and University of Reading, 2006.

Strategic Outsourcing and the Virtual Corporation © Ram Mudambi, Temple University and University of Reading, 2006.

Strategic Outsourcing Key to strategic outsourcing Identifying the company’s basis of competitive advantage and value creation. Outsourcing advantages Efficient subcontractors reduce overall costs. Better product differentiation. Allows for the concentration of available resources. Firm becomes more flexible and responsive. Outsourcing disadvantages Failure to learn from outsourced activity. Too much dependence on a single supplier. Danger of outsourcing value creation activities leading to competitive advantage. © Ram Mudambi, Temple University and University of Reading, 2006.

Diversification Related diversification Entry into new business activity based on shared commonalities in the components of the value chains of the firms – good strategic or resource fit A strategy-driven approach to creating shareholder value Unrelated diversification Entry into a new business area that has no obvious relationship with any area of the existing business. A finance-driven approach to creating shareholder value © Ram Mudambi, Temple University and University of Reading, 2006.

Summary Strategic outsourcing Diversification Corporate strategy – an application of Transactions Cost Economics (TCE) The boundaries of the firm The make-or-buy decision The value chain and Vertical integration Strategic outsourcing Diversification © Ram Mudambi, Temple University and University of Reading, 2006.