1. Economics of Strategy Chapter 3 Vertical Boundaries of the Firm
Besanko, Dranove, Shanley and Schaefer, 3rd Edition
Chapter 3
Vertical Boundaries of the Firm
Slide show prepared by
Richard PonArul
California State University, Chico
 John Wiley  Sons, Inc.

2. Vertical Chain Begins with the acquisition of raw materials
Ends with the sale of finished goods/services
Includes support services such as Finance and Marketing
Organizing the vertical chain is an important part of business strategy

3. Vertical Boundaries of the Firm
Which steps of the vertical chain are to be performed inside the firm?
Which steps of the vertical chain to be out-sourced?
Choice between the “invisible hand” of the market and the “visible hand” of the organization (Make or Buy)

4. Vertically Integrated Firms
In a vertically integrated firm, many of the steps in the vertical chain are performed in-house. Example: Scott Paper
Some firms choose to outsource many of the vertical chain tasks and become vertically disintegrated. Example: Nike

5. Make versus Buy
Decision depends on the costs and benefits of using the market as opposed to performing the task in-house
Outside specialists may perform a task better than the firm can
Intermediate solutions are possible (Examples: Strategic alliances with suppliers, Joint ventures)

6. Support Services Accounting Finance Legal Support Marketing Planning
Human Resource Management

7. Support Services
Support services can be major sources of value creation
UPS – Logistics
Toyota – Human Resource Manager
Nike - Marketing

8. Some Make-or-Buy Fallacies
Firm should make rather than buy assets that provide competitive advantages
Outsourcing an activity eliminates the cost of that activity
Backward integration captures the profit margin of the supplier
Backward integration insures against the risk of high input prices
It makes sense to tie up the distribution channel in order to deny access to the rivals

9. Make-or-Buy and Competitive Advantage
A firm believes that a particular asset is a source of competitive advantage
It turns out the asset is easily available in the market
The belief regarding competitive advantage will have to be reevaluated

10. Outsourcing and Cost
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

11. Backward Integration and Profits
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, what is the reason for its persistence?
Market competition should eventually erode away the economic profit

12. Vertical Integration and Input Price Risk
Instead of vertical integration, forward or futures contracts can be used to hedge input price risk
Another possibility is that the capital tied up in vertical integration could be used to set up a self insurance fund
Vertical integration into a risky activity will add rather than reduce the overall risk

13. Foreclosure of Distribution Channels
Two possibilities
It may be easy to open up new channels
If not, the price paid to acquire the channel will reflect the value
In either case, economic profits do not flow from the foreclosure of distribution channels

14. Benefits of Using the Market
Market firms (outside specialists) may have patents/proprietary information that makes low cost production possible
Market firms can achieve economies of scale that in-house units cannot
Market firms are subject to market discipline, whereas in-house units may be able to hide their inefficiencies behind overall corporate success (Agency and influence costs)

15. Economies of Scale

16. Economies of Scale
A given manufacturer of automobiles may not be able to reach the minimum efficient scale (A*) for anti-lock brakes
An outside supplier may reach the minimum efficient scale by supplying to different automobile manufacturers

17. Economies of Scale
An automobile manufacturer would rather buy anti-lock brakes from an independent supplier than from a competitor
Minimum efficient scale may be feasible for the independent supplier but not for an automobile manufacturer

18. 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 its degree of competition faced by the supplier

19. Make-or-Buy in Insurance
Buying insurance utilizes economies of scale available to insurers
Large firms with sufficient capital can “self-insure”

20. Self-Insurance by British Petroleum
BP self-insures large losses but buys insurance for small losses
Insurers bring in specialized expertise to handle small losses (learning curve)

21. Agency and Influence Costs
The incentives to be efficient and innovative are weaker when a task is performed in-house
Agency costs are particularly problematic if the task is performed by a “cost center” within an organization
It is difficult to internally replicate the incentives faced by market firms
Very important chapter (n. 3: agency and coordination)

22. Influence costs
In addition to agency costs, performing a task in-house will lead to “influence costs” as well
“Internal Capital Markets” allocates scarce capital
Allocations can be favorably affected by influence activities
Resources consumed by influence activities represent “influence costs”

23. Problems in Using the Market
Costs imposed by poor coordination
Reluctance of partners to share valuable private information
Transactions cost that can be avoided by performing the task in-house
Each problem can be traced to difficulties in contracting

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

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

26. 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
One should be able to “map” from each possible contingency to a set of actions
One should be able to define and measure performances
One should be able to enforce the contract

27. Complete Contract (Continued)
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

28. Incomplete Contracts Incomplete contracts Involve some ambiguities
Need not anticipate all possible contingencies
Do not spell out rights and responsibilities of parties completely

29. Factors that Prevent Complete Contracting
Bounded rationality
Difficulties in specifying/measuring performance
Asymmetric information

30. Bounded Rationality Individuals have limited capacity to
Process information
Deal with complexity
Pursue rational aims
Individuals cannot foresee all possible contingencies

31. Specifying/Measuring Performance
Terms like “normal wear and tear” may have different interpretations
Wear and tear is a form of depreciation which is assumed to occur even when an item is used competently and with care and proper maintenance.
Performance cannot always be measured unambiguously

32. Asymmetric Information
Parties to the contract may not have equal access to contract-relevant information
One party can misrepresent information with impurity

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

34. 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

35. Coordination of Production Flows
For successful coordination one party needs to make decisions that depend on the decision made by others
A good fit should be accomplished in several dimensions
Timing
Size
Color
Sequence
R & D

36. Coordination Problems
Without good coordination, bottlenecks arise in the vertical chain
Coordination is especially important when “design attributes” are present
To ensure coordination, firms rely on contracts that specify delivery dates, design tolerances and other performance targets

37. Design Attributes
Design attributes are attributes that need to relate to each other precisely; else significant loss in economic value results
Some examples
Sequencing of courses in MBA curriculum
Fit of auto sunroof glass to aperture
Timely delivery of a critical component

38. Design Attributes
If coordination is critical, administration control may replace the market mechanism
Design attributes may be moved in-house

39. Leakage of Private Information
Firms would not want to compromise the source of their competitive advantage, hence some activities cannot be out-sourced
Sometimes, contracts can be used to protect against leakage of critical information (Example: Non-compete clause for employees)

40. Transactions Costs
If the market mechanism improves efficiency, why do so many of the activities take place outside the price system? (Coase)
Costs of using the market that are saved by centralized direction – transactions costs

41. Transactions Costs
Out-sourcing entail costs of negotiating, writing and enforcing contracts
Costs are incurred due to opportunistic behavior of parties to the contract and efforts to prevent such behavior
Transactions costs explain why economic activities occur outside the price system

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

43. Relationship-Specific Assets
Relation-specific assets are essential for a given transaction
These assets cannot be redeployed for another transaction costlessly
Once the asset is in place, the other party to the contract cannot be replaced costlessly, because the parties are locked into the relationship to some degree

44. Relationship-Specific Assets: Examples
An aluminum refiner invests in a refinery designed to process a particular grade of bauxite ore
The French government invests in transportation infrastructure for Euro-Disney

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

46. 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

47. 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

48. Dedicated Assets
Some investments are made to satisfy a single buyer, without whose business the investment will not be profitable
International systems’ investment in assembly line making integrated circuits for IBM
A defense contractor’s investment in manufacturing facility for making certain advanced weapon systems

49. 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 in a physicians office acquire the skills to use a particular practice management software
Salespersons posses detailed knowledge of customer firm’s internal organization

50. Rent and Quasi-rent
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

51. Rent and Quasi-rent
Firm A makes an investment to produce a component for Firm B after B has agreed to buy from A at a certain price
At that price, A can earn an economic profit of π1
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 π2

52. Rent and Quasi-rent
Rent is the minimum economic profit needed to induce A to enter into this agreement with B (π1)
Quasi-rent is the economic profit in excess on the minimum needed to retain A in the selling relationship with B (π1- π2)

53. The Holdup Problem
Whenever π1 > π2, Firm B can benefit by holding up A and capturing the quasi-rent for itself
A complete contract will not permit the breach
With incomplete contracts and relationship-specific assets, quasi-rent may exist and lead to the holdup problem

54. 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 relation specific assets

55. 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

56. 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

57. 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

58. 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

59. Asset Specificity and Transactions Costs
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