The Vertical Boundaries of the Firm Besanko, Dranove, Shanley, and Schaefer Chapter 3

Agenda Defining Vertical Boundaries The Make Versus Buy Decision Defining a Firm’s Vertical Boundaries Reasons to Buy From the Market Reasons to Do-It-Yourself

Vertical Boundaries The vertical boundaries of the firm are defined as the activities that the firm chooses to do itself rather than having some other firm provide them.

Make Versus Buy Decision Any activity in the process to produce and/or sell a good that is done by the firm is considered to be the “make” decision. Any activity in the process to produce and/or sell a good that is done by some other firm is considered to be the “buy” decision.

The Make or Buy Continuum Arm’s-length market transactions (less integrated) Long-term contracts Strategic alliances and joint ventures Parent/subsidiary relationship Perform activity internally (more integrated)

Upstream Versus Downstream The vertical chain of the economy tends to take raw materials and turns them into goods that are sold to the wholesale or retail market. Production activities closer to raw materials tend to be known as upstream, while activities closer to the wholesale/retail market are considered downstream.

Defining a Firm’s Vertical Boundaries No matter where the firm is in the vertical chain of production, it needs to examine the cost and benefits of using the market to perform activities that are related to its product.

Benefits of Using the Market External firms may be able to achieve economies of scale which your firm may not be able to achieve. External firms are subject to the discipline of the markets which spurs innovation and efficiency.

Cost of Using the Market Coordination of production flows may be compromised. Intellectual property and/or practices may be leaked to competitors. Transaction costs.

Make-or-Buy Fallacies Provided by the Authors A firm should provide a service/product itself rather than buying it from the market, if the service/product is a source of competitive advantage. Firms should purchase a service/product to avoid the costs of producing/providing it itself.

Make-or-Buy Fallacies Provided by the Authors Cont. A firm should provide a service/product to avoid paying a profit margin to an independent firm. A firm should produce a service/product to avoid the high cost of purchasing it when demand is high or supply is scarce for the service/product.

Make-or-Buy Fallacies Provided by the Authors Cont. A firm should produce a service/product to tie up a distribution channel to gain a competitive edge. This can be true under some circumstances, but not all.

Reasons to Buy from the Market The primary reason to buy from the market is to exploit scale and learning economies that can be more easily achieved by the outside firm. A second reason is to avoid bureaucracy effects that tend to occur with large firms which include agency and influence costs.

Exploiting Scale and Learning Economies The outside firm may possess proprietary information or patents which allow it to produce at a lower average cost. The outside firm may gain economies of scale by selling to many firms. The outside firm may gain learning economies by selling to many firms.

Bureaucracy Effect Issues Slacking—The act of not performing in the best interest of the firm. Agency Costs—Cost incurred by a firm due to slacking and efforts to deter slacking. Influence Costs—Cost incurred by a firm when different internal divisions use firm resources to acquire a larger share of the firm’s resources.

Reasons to Make The reason for a firm to provide a service/product itself can be explained by examining the three major costs of using the market. Poor coordination in the vertical chain Reluctance of trading partners to share information Transaction costs

Underlying Problem with Using the Market The major underlying issue that causes the costs of using the market stems from writing and enforcing contracts. In terms of the firm, a contract dictates the terms of exchange from one party to another.

Why Do Firms Use Contracts? A contract gives a set of tasks for each party that is expected to be accomplished. They specify remedies if one of the parties does not fulfill the terms of the contract. To some extant, firms do not trust each other. Contracts provide protection to each party from opportunistic behavior.

Complete Contracting A complete contact covers every possible scenario in the contract that could occur between the parties and includes all remedies. Complete contracting is a difficult task because of: Bounded Rationality Difficulty Specifying or measuring performance Asymmetric Information

Bounded Rationality Bounded rationality is the idea that each party cannot conceivably think of all possible outcomes that can occur regarding a contract. Hence writing a complete contract is considered not possible.

Difficulties Specifying or Measuring Performance It is very difficult for a writer of a contract to completely specify what performance in a contract really means. A measure of performance may not be nonexistent or it may not be agreed upon between the two parties of a contract if not specified well.

Asymmetric Information Asymmetric information occurs when one party in the contract has more information than the other party in the contract. This can lead to opportunistic behavior by the party that has more information.

Contract Law There exists in the United States a body of contract law that stems from common law and the Uniform Commercial Code which facilitates incomplete contracts by providing standard provisions to a wide class of transactions.

Problem with Contract Law It is filled with phrase that are very broad and can be interpreted in different ways. It sometimes depends on costly litigation to fulfill the terms of the contract.

Coordination of Production Flows Contracts are used to coordinate production flows through the vertical channel. Contracts coordinate production flow by: Specifying delivery dates Design tolerances Other performance targets

Coordination of Production Flows Cont. Coordination of production flows can be achieved using the market by hiring a merchant coordinator. A merchant coordinator specializes in linking different parties in the vertical chain.

Leakage of Private Information Induces the Make Decision A firm with important knowledge on production know-how, product design, or consumer information may be more inclined to provide the product or service in-house so the information cannot be easily transferred to a competing firm.

Leakage of Private Information Induces the Make Decision Cont. Patents, trademarks, and copyrights can help protect the leakage of private information, but may not provide the level of production a firm is looking for. Non-compete clauses can be used to make sure employees of your company do not move to a rival company taking your secrets with them.

Transaction Costs Transaction costs are the costs that are associated with using the market. These costs include: Contract negotiation, writing, and enforcement Opportunism due to asymmetric information

Transaction Costs Cont. Transaction costs can be affected by the following: Relationship Specific Assets Quasi-Rents The Hold-Up Problem

Relationship Specific Assets These assets are procured by a firm in order to support a transaction. These assets tend to be difficult to redeploy to other transactions without incurring some form of cost. This provides disincentive to the firm to change customers.

Relationship Specific Assets Asset specificity can come in many forms including: Site Specificity Physical Asset Specificity Dedicated Assets Human Asset Specificity Asset specificity creates sunk costs.

Rents and Quasi-Rents The textbook authors view rent as the profit that you would receive by investing in a relationship specific asset. The textbook authors view quasi-rent as the difference between rent and the value of the asset used in its next best alternative.

The Hold-Up Problem A hold-up problem occurs when a firm tries to renegotiate the terms of a deal with its trading partner to capture part of the quasi-rents. This is primarily due to opportunism and incomplete contracting.

The Hold-Up Problem and Transaction Costs The hold-up problem can raise transaction costs in the following four ways: More difficult negotiations and more frequent renegotiations Increased investments that improve bargaining position Distrust A reluctance of firms to want to make relationship specific investment