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 and  ends with the sale of finished goods/services. Organizing the vertical chain is an important part of business strategy

The Vertical Chain Vertically integrated firms perform all the tasks in the vertical chain in-house. Vertically disintegrated firms 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 be out-sourced. The choice is between the market and the organization: it’s a make or buy decision.

Make versus Buy There is a continuum of possibilities between the two extremes  Arms length transactions  Long term contracts  Strategic alliances and joint ventures  Parent/subsidiary relationship  Activity performed internally

Upstream, Downstream Early steps in the production process are upstream (Timber for furniture) Later steps are downstream (finished goods in showrooms) Support services are provided all along the chain

Make-or-Buy Continuum

Vertical Chain of Production

Defining Boundaries Firms need to define their vertical boundaries. Outside specialists who can perform vertical chain tasks are market firms. Market firms are often recognized leaders in their field (Example: Aramex).

Market Firms Benefits of using market firms  Economies of scale achieved by market firms  Value of market discipline Costs  Problems in coordination of production flows  Possible leak of private information  Transactions costs

Some Make-or-Buy Fallacies 1. Firm should make rather than buy assets that provide competitive advantages 2. Outsourcing an activity eliminates the cost of that activity 3. Making instead of buying captures the profit margin of the market firms 4. Vertical integration insures against the risk of high input prices 5. Making ties up the distribution channel and denies access to the rivals

Make-or-Buy & Competitive Advantage Fallacy 1: Firm should make rather than buy assets that provide competitive advantages A firm may believe that a particular asset is a source of competitive advantage But if the asset is easily available in the market the belief regarding competitive advantage will have to be reevaluated

Outsourcing and Cost Fallacy 2: Outsourcing an activity eliminates the cost of that activity It should not matter if the costs of performing 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 Fallacy 3: Making instead of buying captures the profit margin of the market firms The supplier’s profit margin may not represent any economic profit, and profit margin should “pay” for the capital investment and the risk borne If the supplier is earning economic profit, is there a reason for its persistence? Market competition should eventually erode away any economic profit

Vertical Integration & Input Price Risk Fallacy 4: Vertical integration insures against the risk of high input prices Instead of vertical integration, long term contracts can be used to reduce input price risk Forward or futures contracts can also be used to hedge input price risk Alternately the capital tied up in vertical integration could be used as a contingency fund to deal with price fluctuations.

Foreclosure of Distribution Channels Fallacy 5: Making ties up the distribution channel and denies access to the rivals Acquiring a downstream monopoly supplier may seem to be a way to tie up channels and increase profits Three possible limitations  Possible violation of anti trust laws  Price paid for the downstream firm may reflect the full value of the monopoly power  Competitors may be able to open new distribution channels

Foreclosure of Distribution Channels Fallacy 5: Making ties up the distribution channel and denies access to the rivals Foreclosure* can succeed if:  Upstream monopolist is unable to commit to higher prices (discounting to more price sensitive buyers = price discrimination)  Upstream firm is creating a network by acquiring several downstream firms

Reasons to Buy For next class CAREFULLY read Reasons to Buy in p127 until pgh2 of p129. Market firms may have patents or proprietary 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 learning economies

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 minimum efficient scale (A * ) by supplying to different automobile manufacturers The cost is lowered by using the outside supplier

Economies of Scale Minimum efficient scale may be feasible for the independent supplier but not for an automobile manufacturer. Automobile manufacturers would rather buy anti-lock brakes from an independent supplier than from a competitor. (Page128, pgh3)

Economies of Scale Will the outside supplier charge C* (its average 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 by employees and the administrative effort to deter slacking. When there are joint costs measuring and rewarding individual unit’s performance is difficult. It is difficult to internally replicate the incentives 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 in the market allows its managers to live with the agency costs

Influence Costs Performing a task in-house will lead to influence costs. Internal Capital Markets allocates scarce capital 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 against pressures to become more competitive. Large vertically integrated firms are more prone to influence cost problems than small independent firms.

Reasons to Make 1. Costs imposed by poor coordination 2. Reluctance of partners to develop and share private information 3. Transactions cost that can be avoided by performing the task in-house Each of the three problems can be traced to difficulties in contracting

Role of Contracts Firms often use contracts when certain tasks are performed outside the firm. The contracts list  the set of tasks that need to be performed and  the remedies if one party fails to fulfill its obligation.

Contracts Contracts protect each party to a transaction from opportunistic behavior of other(s) Contracts’ ability to provide this protection depends on i. the “completeness” of contracts ii. the body of contract law

i. Complete Contract A complete contract stipulates what each party should do for every possible contingency No party can exploit others’ weaknesses To create a compete contract one should be able to contemplate all possible contingencies

i. Complete Contract (Cont.) A complete contract maps each possible contingency to a set of stipulated actions One should be able to define and measure performance The contract must be enforceable

i. Complete Contract (Cont.) To enforce a contract, an outside party (judge, arbitrator) should be able to  observe the contingency  observe the actions by the parties  impose the stated penalties for non-performance Real life contracts are usually incomplete contracts

i. Incomplete Contracts Incomplete contracts involve some ambiguities They do not anticipate all possible contingencies They do not spell out rights and responsibilities of parties completely

i. Factors that Prevent Complete Contracting 1. Bounded rationality 2. Difficulties in specifying/measuring performance 3. Asymmetric information

i.1. Bounded Rationality Individuals have limited capacity to  process information  deal with complexity  pursue rational aims Individuals cannot foresee all possible contingencies

i.2. Specifying/Measuring Performance What constitutes fulfillment of a contract may have some residual vagueness. Terms like “normal wear and tear” may have different interpretations. Performance cannot always be measured unambiguously.

i.3. Asymmetric Information Parties to the contract may not have equal access to contract-relevant information. The knowledgeable party can misrepresent information with impunity. Contracting on items that rely on this information is difficult.

ii. Contract Law Contract law facilitates transactions when contracts are incomplete.  Parties need not specify provisions that are common to a wide class of transactions.

ii. Limitations of Contract Law Doctrines of contract law are in broad language that could be interpreted in different ways Litigation can be a costly way to deal with breach of contract  Litigation can be time consuming  Litigation weakens the business relationship

Coordination of Production Flows Firms make decisions that depend in part on the decisions made by other firms along the vertical chain. A good fit will have to be accomplished in all dimensions of production. (Examples: Timing, Size, Color and Sequence)

Coordination Problems Without good coordination, bottlenecks**** arise in the vertical chain To ensure coordination, firms rely on contracts Firms also use merchant coordinators – independent specialists who work with firms along the vertical chain

Coordination Problems Coordination is especially important when design attributes are present Design attributes are attributes that need to relate to each other in a precise way. 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, ‘administration control’ may replace the ‘market mechanism’ Design attributes may be moved in-house

Leakage of Private Information Firms do not want to compromise the source of their competitive advantage. Private information on product design or production know-how may be compromised when outside firms are used in the vertical chain.

Leakage of Private Information Well defined patents can help but may not provide full protection Contracts with non-compete clauses can be used to protect against leakage of information  In practice, non-compete clauses can be hard to enforce

Transactions Costs If the market mechanism improves efficiency, why do so many of the activities take place outside the price system? (Coase) Transactions costs: Costs of using the market that are saved by centralized direction – Outsourcing entails costs of negotiating, writing and enforcing contracts

Transactions Costs Costs incurred due to opportunistic behavior of parties to the contract. And efforts to prevent such behavior are transaction costs as well. Transactions costs explain why economic activities occur outside the price system (inside the firm).

Transactions Costs Sources of transactions costs  Investments that need to be made in relationship specific assets  Possible opportunistic behavior after the investment is made (holdup* problem)  Quasi-rents (magnitude of the holdup problems)

Relationship-Specific Assets Relation-specific assets are assets essential for a given transaction These assets cannot be redeployed for another transaction without cost Once the asset is in place, the other party to the contract cannot be replaced without cost, because the parties are locked into the relationship to some degree

Forms of Asset Specificity Relation-specific assets may exhibit different forms of specificity  Site specificity  Physical asset specificity  Dedicated assets  Human asset specificity

Site Specificity Assets may have to be located in close proximity to economize on transportation costs and inventory costs and to improve process efficiency  Cement factories are usually located near lime stone deposits  Can-producing plants are located near can-filling plants

Physical Asset Specificity Physical assets may have to be designed specifically for the particular transaction  Molds for glass container production custom made for a particular user  A refinery designed to process a particular grade of bauxite ore

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 special needs of some customers  A defense contractor’s investment in manufacturing facility for making certain advanced weapon systems

Human Asset Specificity Some of the employees of the firms engaged in the transaction may have to acquire relationship-specific skills, know-how and information  Clerical workers acquire the skills to use a particular software (E.g.. MyEconLab)  Salespersons posses detailed knowledge of customer firm’s internal organization

Fundamental Transformation Prior to the investment in relationship specific assets there are many trading partners. Once the investment is made the situation becomes a bargaining situation with a small number partners Relationship specific assets cause a fundamental transformation in the relationship

Rents and Quasi-Rents The term rent denotes economic profits – profits after all the economic costs, including the cost of capital, are deducted Quasi-rent is the excess economic profit from a transaction compared with economic profits available from an alternate transaction

Rents and Quasi-Rents Firm A makes an investment to produce a component for Firm B after B as agreed to buy from A at a certain price At that price A can earn an economic profit of π 1 If B were to renege on the agreement and A is forced to sell its output in the open market, the economic profit will be π 2

Rents and Quasi-Rents Before the investment: Rent is the minimum economic profit needed to induce A to enter into this agreement with B (π 1 ) After the investment: Quasi-rent is the economic profit in excess on the minimum needed to retain A in the selling relationship with B (π 1 - π 2 )

The Holdup Problem Whenever π 1 > π 2, Firm B can benefit by holding up A and capturing the quasi-rent ( or part of it ) for itself A complete contract will not permit the breach. But with incomplete contracts and relationship-specific assets, quasi-rent may exist and lead to the holdup problem

Effect on Transactions Costs The holdup problem raises the cost of transacting exchanges  Contract negotiations become more difficult  Investments may have to be made to improve the ex-post bargaining position  Potential holdup can cause distrust  There could be underinvestment in relationship specific assets

Holdup and Contract Negotiations When there is potential for holdup, contract negotiations become tedious as each party attempts to build in protections for itself Temptations on the part of either party to holdup can lead to frequent renegotiations There could be costly disruptions in the exchange

Holdup and Costly Safeguards Potential for holdup may lead parties to invest in wasteful protective measures  Manufacturer may acquire standby production facility for an input that is to be obtained from a market firm  Floating power plants are used in place of traditional power plants to avoid site specific investments

Holdup and Distrust Potential holdups cause distrust between parties and raise the cost of transactions  Distrust can make contracting more costly since contracts will have to be more detailed  Distrust affects the flow of information needed to achieve process efficiencies

Holdup and Underinvestment When there is a holdup, the investment made in relationship-specific assets loses value Anticipating holdups, firms will make otherwise sub-optimal level of investments and suffer higher production costs

The Holdup Problem: Summary Relation-specific assets support a particular transaction Redeploying to other uses is costly Quasi rents become available to one party and there is incentive for a holdup Potential for holdups lead to  Underinvestment in these assets  Investment in safeguards  Reduced trust

Double Marginalization Vertical integration helps if both the upstream firm and the downstream firm have market power Upstream firm sets its price above marginal cost Vertical integration increases output, lowers the final price and increases the profits

The Make-or-Buy Decision Tree