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Vertical Scope of the Firm
What are the appropriate (efficient) organizational boundaries of the
firm?
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VERTICAL PRODUCT GEOGRAPHICAL AREAS
SINGLEFIRM
SEVERAL SPECIALIZED FIRMS
V1
V2
V3
V1
V2
V3
P1 P2 P3 A1 A2 A3
P1 P1 P1 A1 A2 A3
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
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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
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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
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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
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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
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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.
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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
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The Choice between Market and Hierarchy
BENEFITS
COSTS
MARKET HIERARCHY
Informational Efficiencies
High-Powered Incentives
Transaction Costs
Market Power
Authority
Coordination
Bureaucracy
Agency theory
Source: Collis and Montgomery, Corporate Strategy, 1997
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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 information The 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
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How uncertain is market demand? The greater the demand uncertainty--the more costly is VI.
Are the two stages similar in terms of The 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
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Intermediate Forms of Organization: A Continuum of Governance Arrangements
SPOTMARKET
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
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Spot sales/ purchases
Long-term contracts
Agency agreements
Franchises
Vertical integration
Joint ventures
Informal supplier/ customer
relationshipsSupplier/ customer
partnerships
Low Degree of Commitment High
Low
High
Fo
rmal
izat
ion
Different Types of Vertical Relationships
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995
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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
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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
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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
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Flow Chart for Vertical Integration Decisions
INSIDE HIERARCHY
YES
YES
YES
TRADEOFF
YES
MARKET CONTRACT
RENT APPROPRIABILITY
HOLD-UP TRANSACTION
COSTS
INCENTIVES AGENCY COSTS
COORDINATION FIAT
NO NO
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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
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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
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(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:
ExternalCustomer
Internal ActivitiesExternal Supplier
Be Better Than Competitors
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Ross Perot to GM Management:
“You don’t need to own a dairy to buy milk.”
General Conclusion