1. Vertical Chain

2. Vertical Integration
The degree to which the firm controls the chain.

3. Vertical Integration
Upstream Integration – towards raw materials

4. Vertical Integration
Downstream Integration – towards end customer

5. Boundaries of the Firm
The question for a firm is “Where to draw the boundary.” The answer is closely tied to material in CH 3.
Expanding is integrating
Contracting is outsourcing

6. Outsourcing
South Park – “They took our jobs”
Dell expanding in India -
The Dubai Ports deal.
A guide to best practice by Accenture:

7. Should a firm vertically integrate?
Pros of doing it in-house
Avoid double markup problem
Upstream Firm: MC=10 and No Fixed Cost
Downstream Firm: P= 110-Q, MR=110-2Q
Only cost to D is price set by U

8. Double Mark Up Problem What will MC to D look like? $/q
Given a price set by U, what quantity will D buy?
$/q PD
MCU
MRD q

9. Double Mark Up Problem $/q So MRD=PU MRU=110-4Q
What quantity will be traded?
How much will each firm earn? PD
MCU
MRU
MRD=PU q

10. Double Mark Up Problem $/q Profits U: 50x25=1250 Profits D: 25x25= 625
PD = 85
PU = 60 PD
MCU
MRU
MRD=PU q
QD =25

11. Double Mark Up Problem with Vertical Integration Profits: 50x50 = 2500
&
Consumer Surplus Increased
$/q
P = 60 P MC MR
Q =50 q

12. Other ways to Avoid Double Mark-up
Resale Price Maintenance: Up stream firm sets price that downstream firm can charge.
Manufactures Suggested Retail Price (MSRP).
Two-part Tariff

13. Should a firm vertically integrate?
Pros of doing it in-house
No Hold Up Problem
ex: U invests ($5M) in equipment and training to produce component (MC= $1) specific to D.
The investment becomes a sunk cost for U.
D could offer only $2 on 1M units. U would take it as it increases profits, but overall U earns a loss.
Therefore, U is hesitant of undertaking this investment.

14. Should a firm vertically integrate?
Pros of doing it in-house
Minimize Supply Disruptions
Reduced Externalities
Monitoring Quality
Lower Contracting and Transaction Costs
Taxes and Regulation
Centralized Decision Making

15. Should a firm vertically integrate?
Pros of outsourcing
Flexible
Economies of Scale
Specialized Knowledge
Decentralized Decision Making
Focus on Core Competencies

16. Integration vs Outsourcing choosing along a continuum

17. Asset specificity, uncertainty, and the procurement decision

18. Other Vertical Relationships
Hybrid Arrangements
Strategic Alliances
Long Term Contracting
Joint Ventures