Chapter 20 Managing Vertical Relationships COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Review of Chapter 19 Companies are principals trying to get their divisions (agents) to work profitably in the interests of the parent company. Transfer pricing does not merely transfer profit from one division to another; it can result in the movement of assets to lower-value uses. Efficient transfer prices are set equal to the opportunity cost of the asset being transferred. A profit center on top of another profit center can result in too few goods being sold; one common way of addressing this problem is to change one of the profit centers into a cost center.

Review of Chapter 19 (cont.) Companies with functional divisions share functional expertise within a division and can more easily evaluate and reward division employees. However, change is costly, and senior management must coordinate the activities of the various divisions. Process teams are built around a multi-function task and are evaluated based on the success of the project on which they are working. When divisions are rewarded for reaching a budget threshold, they have an incentive to lie to make the threshold as low as possible to make sure they get their bonuses. In addition, they will often pull sales into the present, and push costs into the future, to make sure they reach the threshold level.

Anecdote: Large Power Company Electricity sold to customers at rates regulated by the state “PUC”  Allowed to earn nine percent return on capital The Power Company is contemplating purchasing the Coal Mine that supplies them with coal  Form a multi-divisional company  Direct the Coal Division to raise the transfer price of coal sold to the Power Division Increase in the price of coal raises the marginal cost of producing electricity  Under the profit regulation, allows the Power Division to raise electricity prices  Coal Mining Division earns more on the coal it sells  Power Division is allowed to raise the regulated price of electricity so that its profit does not fall In other words, the Coal Mine is more valuable as a sister division to the Power Company, than it is as an independent company

Caveat: Beware Acquisitions Do NOT buy a customer or supplier simply because they are profitable Without some kind of synergy, the value of the upstream supplier or competitor is exactly equal to the size of its profit stream – not moving assets to higher value uses Discussion: AT&T Cable Acquisitions

Evading Regulation Motive One of the simplest and easiest-to-understand reasons for vertical integration If there is unrealized profit at one stage of the vertical supply chain – as happens when there are regulations preventing one firm from earning higher profit – vertical integration, tying, or bundling can give the regulated firm a way to evade regulation and earn higher profit Discussion: Rent Control Discussion: Multi-National Companies

Solving the Double-Markup Problem Discussion: Gasoline refiners selling branded gasoline This problem can be analyzed more generally as a prisoners’ dilemma faced by any two firms in the same vertical supply chain or by any two firms selling complementary goods The double markup problem occurs when firms selling complementary products set price in competition with each other Vertical integration is one way of addressing the double marginalization problem – commonly owned firms can coordinate more easily on lower prices to raise profit

Aligning Retailer Incentives with Manufacturer Goals Discussion: Getting retailers to invest in demand-enhancing services  With a smaller profit slice, retailers may under-invest  Hard to write complete contracts to cover all cases  Intra-brand competition can be controlled by means such as granting exclusive territories, setting minimum retail prices, etc.  Guarantees retailers a higher profit level creates incentive to provide demand-increasing services  Examples?? Limiting intra-brand competition also helps reduce free-riding Many of these tactics may be illegal under antitrust laws Especially for companies with dominant market shares

Price Discrimination Two separate consumer groups who use same product in different manners Integrating downstream can allow manufacturer to price discriminate Example: Herbicide users (home gardeners and farmers) Price discrimination at the wholesale level is much more difficult (and may be illegal)

Outsourcing The opposite of vertical integration – but decisions should employ the same logic Outsource an activity to an upstream supplier or downstream customer only if they can do it better or more cheaply than you Typical reason is to gain advantages of economies of scale or scope Consider whether you are sacrificing any integration benefits before you outsource

Alternate Intro Anecdote The Aluminum Company of America (Alcoa) was the only domestic supplier of aluminum ingots prior to 1930, which were used for a variety of purposes  An addition to the production process in the iron and steel industry, used to improve the quality of the final product.  Manufacture of cooking utensils  Production of electric cable  Automobile and aircraft parts constituted the final two end markets. Consumers in these diverse markets varied widely in their willingness to pay for aluminum ingots.  Demand for aluminum in the iron/steel industry and in the aircraft industry was relatively inelastic  In the other three industries, demand was much more elastic

Alternate Intro Anecdote (cont.) The potential for arbitrage created a barrier to implementing a scheme to increase prices to iron/steel and aircraft consumers while generally reducing price to the other three markets. To successfully implement its price discrimination scheme, Alcoa was forced to forward integrate into the three relatively elastic markets. By moving into the cookware, electric cable, and automotive parts markets, Alcoa gained control over potential resales of aluminum ingot and was able to maintain high prices to the iron/steel and aircraft parts markets.