1. MKT 450 Strategic Management Mishari Alnahedh

2. LECTURE 8: VERTICAL INTEGRATION

3. Three Dimensions of Scope are:
The Scope of the Firm
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Business Strategy is concerned with how a firm competes within a particular market.
Corporate Strategy is concerned with where a firm competes, i.e. the scope of its activities
Three Dimensions of Scope are:
Vertical Scope
Geographical Scope
Product Scope
© 2013 Robert M. Grant

4. Gaining Synergies via Vertical Integration
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Make vs. Buy
The number of stages in a product’s or service’s value chain that a particular firm engages in defines that firm’s level of vertical integration.
Forward integration: When Coca-Cola began buying its previously franchised independent bottlers.
Backward integration: When Home Box Office began producing its own movies for screening on the HBO Cable Channel.

5. Understanding the Value Chain
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Raw Materials
Backward Integration
Diversification
Manufacturing
Forward Integration
Distribution

6. Market Power Efficiency Why Vertically Integrate ? Entry Barriers
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Market Power
Entry Barriers
Downstream Price Maintenance
Upstream Power Over Price
Efficiency
Specialized Assets & the Holdup Problem
Protecting Product Quality
Improved Scheduling

7. Costs and Benefits of Vertical Integration
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Changing ideas about the efficiency of large corporations as organizers of economic activity have exerted a strong influence on firms’ vertical integration strategies
Thirty years ago, the dominant belief was that vertical integration offered superior coordination as well as protection from the vagaries of the market
The prevailing wisdom today is that any benefits of vertical integration tend to be outweighed by the greater advantages of specializing in a narrow range of vertical activities

8. Market Economy vs. Corporate Economy
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What led to the firm becoming the more efficient organizing device?
Technology: telegraph, telephone, and computer
Management theories and methods
Over time, the administrative costs of the firm has dropped, as compared with the transaction costs of markets

9. The Proportion of Total Output Contributed by the Largest Companies
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10. Vertical Scope Product Scope Geographic Scope
The Scope of the Firm’s Activities
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Vertical Scope
What range of vertically linked activities should the firm encompass?
Product Scope
How specialized should the firm be in terms of the range of products it supplies?
Geographic Scope
What is the optimal geographical spread of activities for the firm?

11. Market Mechanism vs. Administrative Mechanism
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Verticall Scope
Product Scope
Geographical Scope
[A] Single
Integrated
Firm V1 V2 V3 P1 P2 P3 C1 C2 C3
[B] Several
Specialized
Firms Linked
by Markets V1 P1 P2 P3 C1 C2 C3 V2 V3
In situation [A] businesses 1, 2 & 3 are integrated within a single firm.
In situation [B] businesses 1, 2 & 3 are independent firms linked by markets.
Which situation is more efficient?
—Depends upon whether the administrative costs of the integrated firm are less than the transaction costs of markets?
© 2013 Robert M. Grant

12. Which is more efficient?
Sources of Transaction Costs
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Which is more efficient?
Several specialist firms linked by market contracts
Several specialist firms linked by employment contracts, under common ownership
Costs associated with market contracts
Search costs involving purchasing and sales; negotiation and contract drawing costs; monitoring costs; enforcement costs of arbitration or litigation
Costs associated with employment contracts
Administrative costs of organizing within firms for optimal scale of operation, distinctive capabilities, high-powered incentives

13. Example: CHICKEN RUN
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Tyson Foods has made vertical integration work in the chicken business -- and helped make the poultry into the nation's most popular meat.
In addition to the steps outlined below, a Tyson-owned feed mill produces 16 million pounds weekly to feed chickens at every stage up to slaughter
1. Tyson-Owned Breeding Stock
2. 16 Contract Pullet Farms: Young hens raised to 20 weeks of age
3. 42 Contract Egg-Laying Farms: Hens begin laying eggs at 26 weeks
4. Tyson-Owned Hatchery in Stillwell, Okla. Eggs hatch in 21 days
Contract Chicken Farmers: Chicken reach slaughter weight in 51 days
6. Noel, Mo., Processing Plant: Processes 1.25 million chickens weekly
Source: Tyson Foods

14. The Shifting Boundary Between Firms and Markets
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Time Period
Main Trend
Factors Changing the Relative Efficiency of Firms and Markets
Expanding the scale and scope of firms
Administrative costs of firms fall due to:
Advancing technology in transport, communication, and IT
Advances in management—accounting systems, scientific management, organizational innovations
Biggest firms downsize: outsourcing; refocusing on core business
More turbulent external environment increases administrative costs of big firms.
New digital technologies available to small firms and individuals as well as big corporations
Global consolidation of many industries: (e.g. steel, oil, beer, banking)
Globalization of markets
Big corporations more effective at reconciling complexity with responsiveness
© 2013 Robert M. Grant

15. Benefits of VI The Costs and Benefits of Vertical Integration
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Benefits of VI
Technical economies from integrating processes e.g. iron and steel production
But doesn’t necessarily require common ownership
Avoids transactions costs of market contracts in situations where there are:
Small numbers of firms
Transaction-specific investments
Opportunism and strategic misrepresentation
Taxes and regulations on market transactions
Superior Coordination
© 2013 Robert M. Grant

16. Costs of VI The Costs and Benefits of Vertical Integration
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Costs of VI
Differences in optimal scale of operation between different stages of production: prevents balanced vertical integration
Inhibits development of distinctive capabilities
Difficulties of managing strategically different businesses
Incentive problems: lack of “high-powered” incentives
Limits flexibility:
In responding to demand fluctuations
In responding to changes in technology, customer preferences, etc.
Compounding of risk
© 2013 Robert M. Grant

17. Vertical Integration vs. Outsourcing
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How many firms are available to transact with?
The few the companies, the more attractive is VI
Is transaction-specific investment needed?
If yes, VI more attractive
Does limited information permit cheating?
VI can limit opportunism
Are taxes or regulation imposed on transactions?
VI can avoid them
Are future market conditions uncertain?
Uncertainty favors VI
Do the different stages have similar optimal stages of operation?
Greater the similarity, the more attractive is VI
Are the two stages strategically similar?
Strategic similarity favors VI
Is entrepreneurial initiative required?
If so, VI may blunt high-powered profit incentives
How uncertain is market demand?
Greater the unpredictability – the more costly VI
Are risks compounded by linkages between vertical stages?
VI increases risk
© 2013 Robert M. Grant

18. Steel strip production Canning of food, drink, oil, etc.
The Value Chain for Steel Cans
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Iron Ore Mining
Steel production
Steel strip production
Can making
Canning of food, drink, oil, etc.
VERTICAL
INTEGRATION
VERTICAL
INTEGRATION
AND MARKET
CONTRACTS
MARKET
CONTRACTS
MARKET
CONTRACTS
What factors explain why some stages are vertically integrated, while others are linked by market transactions?
© 2013 Robert M. Grant

19. Be Better Than Competitors
Summary: Creating Value in Vertical Activities
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Be Better Than Competitors
(1) In determining whether activities should be internal or external
(2) In coordinating these activities along the value chain
Vertical Scope of the Firm 20 Voigt; Fall 1998

20. Today’s Main Takeaway - Conclusion
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How to identify the relative efficiencies of firms and markets in organizing economic activity and apply the principles of transaction cost economics to determine the boundaries of firms
How to assess the relative merits of vertical integration and market transactions in organizing vertically related activities and understand the circumstances that influence their comparative advantages
Identify a range of possible relationships among vertically related firms, including spot market transactions, long-term contracts, franchise agreements, and alliances