1. Vertical Scope of the Firm What are the appropriate (efficient) organizational boundaries of the firm?

2. Vertical Scope of the Firm 2 Voigt, Fall, 1998 VERTICALPRODUCTGEOGRAPHICAL AREAS SINGLE FIRM SEVERAL SPECIALIZED FIRMS V1V2V3V1V2V3 V1V1 V2V2 V3V3 P 1 P 2 P 3 A 1 A 2 A 3 P1P1 P1P1 P1P1 A1A1 A2A2 A3A3 Transaction Costs and the Scope of the Firm In relation to each dimension of scope, the basic issue is relative efficiency of the single firm compared with several specialist firms. Common Issue: What are transactions costs of markets compared with administrative/governance costs of the firm? Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

3. Vertical Scope of the Firm 3 Voigt, Fall, 1998 Creating Efficiently Designed Corporations The corporate hierarchy will be efficient when it can be shown to be the organizational arrangement that minimizes the sum of production and governance costs. Production costs are the direct costs incurred in the physical production and exchange of the item subject to the transaction. Governance costs include costs of negotiating, writing, monitoring, enforcing, and possibly also bonding to the terms of the organizational arrangement. Historically, production costs were the primary drivers of firm boundaries. More recently, attention has been placed on governance costs. Source: Collis and Montgomergy, Corporate Strategy, 1997

4. Vertical Scope of the Firm 4 Voigt, Fall, 1998 Vertical integration (VI) is a firm’s ownership of vertically related activities. Vertical integration can occur in 2 directions: Backward Integration (producing own inputs) Forward Integration (disposing of own outputs) Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Defining Vertical Integration

5. Vertical Scope of the Firm 5 Voigt, Fall, 1998 Benefits of Vertical Integration Economies of combined operations Economies of internal control and coordination Assure supply or demand Better quality control and coordination Protect proprietary technology Gain access to information Avoid costs of dealing with the market Gain (or offset) market power Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

6. Vertical Scope of the Firm 6 Voigt, Fall, 1998 The Costs of Vertical Integration Differences between stages in optimal scale of operation Managing strategically different businesses Agency costs Higher capital investment Reduced Flexibility in responding to demand uncertainty in responding to changes in technology, customer preferences, etc. Foreclose access to outside information/technology Dulled incentives Costs of bureaucratic hierarchy Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

7. Vertical Scope of the Firm 7 Voigt, Fall, 1998 Benefits of the Market Informational efficiencies i.e. price mechanisms and decentralized decision-making Powerful incentive mechanisms i.e. better alignment self-interested behavior and incentives Source: Collis and Montgomery, Corporate Strategy, 1997 e.g. Direct production costs of individual proprietors transacting with one another on the market will be lower than those involving employees inside a corporate hierarchy.

8. Vertical Scope of the Firm 8 Voigt, Fall, 1998 Costs of the Market: Transaction Costs and Market Failures Market relationships fail when they are subject to: Opportunism (lying, cheating, stealing, acting self-interestedly) Asset specificity (small numbers) ( Location specificity, physical asset specificity, and human asset specificity) Uncertainty (inability to predetermine all future eventualities) High Frequency (repeated exposure to hold up) It is the possibility of firms acting opportunistically that causes market failure. The other three conditions create the opportunity for a firm to act opportunistically. Other Sources include resource inseparability, information impactedness, and market power Source: Collis and Montgomery, Corporate Strategy, 1997

9. Vertical Scope of the Firm 9 Voigt, Fall, 1998 The Choice between Market and Hierarchy BENEFITS COSTS MARKETHIERARCHY Informational Efficiencies High-Powered Incentives Transaction Costs Market Power Authority Coordination Bureaucracy Agency theory Source: Collis and Montgomery, Corporate Strategy, 1997

10. Vertical Scope of the Firm 10 Voigt, Fall, 1998 How many firms are there in the The fewer the companies, the greater vertically related activity? the attraction of VI. Do transactions-specific investments The greater the requirements for need to be made by either party? specific investments, the more attractive is VI. Does limited availability of informationThe greater the difficulty of specifying provide opportunities to the contracting and monitoring contracts, the greater firm to behave opportunistically (i.e., the advantages of VI. cheat)? Are market transactions subject to taxes VI is attractive if it can circumvent and regulations? taxes and regulations. How much uncertainty exists with regard Uncertainty raises the costs of writing to the circumstances prevailing over the and monitoring contracts, and period of the contracts? provides opportunities for cheating, therefore increasing the attractiveness of VI. Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Factors that are important in determining the merits of vertical integration compared to market transactions

11. Vertical Scope of the Firm 11 Voigt, Fall, 1998 How uncertain is market demand?The greater the demand uncertainty-- the more costly is VI. Are the two stages similar in terms ofThe greater the dissimilarity in scale- the optimal scale of operations? the more difficult is VI. How strategically similar are the differentThe greater the strategic dissimilarity stages in terms of key success factors the more difficult is VI. and the resources and capabilities required for success? Does VI increase risk through requiring The heavier the investment heavy investments in multiple stages requirements and the greater the and compounding otherwise independent risks at each stage --the independent risk factors? more risky is VI. Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Factors that are important in determining the merits of vertical integration compared to market transactions

12. Vertical Scope of the Firm 12 Voigt, Fall, 1998 Intermediate Forms of Organization: A Continuum of Governance Arrangements SPOT MARKET INTERNAL HIERARCHY (full integration) RANGE OF INTERMEDIATE FORMS LONG-TERM CONTRACTS STRATEGIC ALLIANCES JOINT VENTURES QUASI- VERTICAL INTEGRATION (PARTIAL OWNERSHIP) Intermediate relationships may combine the benefits of both market transactions and internalization

13. Vertical Scope of the Firm 13 Voigt, Fall, 1998 Spot sales/ purchases Long-term contracts Agency agreements Franchises Vertical integration Joint ventures Informal supplier/ customer relationships Supplier/ customer partnerships LowDegree of CommitmentHigh Low High Formalizatio n Different Types of Vertical Relationships Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

14. Vertical Scope of the Firm 14 Voigt, Fall, 1998 Designing Vertical Relationships: Long-Term Contracts and Quasi-Vertical Integration Intermediate between spot transactions and vertical integration are several types of vertical relationships --such relationships may combine benefits of both market transactions and internalization Key issues in designing vertical relationships -- How is risk allocated between the parties? -- Are the incentives appropriate? Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

15. Vertical Scope of the Firm 15 Voigt, Fall, 1998 Recent Trends in Vertical Relationships (US) From competitive contracting to supplier partnerships (e.g. auto industry). From vertical integration to outsourcing (not just components, also IT, distribution, and administrative services). Diffusion of franchising. Technology partnerships (e.g. IBM-Apple; Canon-HP). Inter-firm networks. General conclusion: Boundaries between firms and markets becoming increasingly blurred. Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

16. Vertical Scope of the Firm 16 Voigt, Fall, 1998 JAPANESE APPROACH Extensive use of subcontracting Mitigate opportunism via: equity links personnel links long-term relationships implicit contracts Close coordination of suppliers and assemblers product design JIT delivery Source: Mari Sakakibara, UCLA, 1997

17. Vertical Scope of the Firm 17 Voigt, Fall, 1998 Flow Chart for Vertical Integration Decisions INSIDE HIERARCHY YES TRADEOFF YES MARKET CONTRACT RENT APPROPRIABILITY HOLD-UP TRANSACTION COSTS INCENTIVES AGENCY COSTS COORDINATION FIAT NO

18. Vertical Scope of the Firm 18 Voigt, Fall, 1998 Action Steps in Scope of Firm Decisions Step 1: Disaggregate the Industry Value Chain Step 2: Competitive Advantage –Do you have a competitive advantage in the performance of the activity? Step 3: Market Failure –Is there a clear market failure? Are the costs of market governance extremely high? Can dominant firms exercise market power? Step 4: Need for Coordination –Is there an ongoing need for intensive coordination? Are continual and integrated changes required? Is there a distinct interface between activities? Source: Collis and Montgomery, Corporate Strategy, 1997

19. Vertical Scope of the Firm 19 Voigt, Fall, 1998 Action Steps (cont’d) Step 5: Importance of Incentives –How high are agency costs inside the hierarchy? How much do worker skill and effort affect outcomes? Can an effective incentive scheme be designed? Which is more important: coordination or high-powered incentives? Source: Collis and Montgomery, Corporate Strategy, 1997

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

21. Vertical Scope of the Firm 21 Voigt, Fall, 1998 Ross Perot to GM Management: “You don’t need to own a dairy to buy milk.” General Conclusion