Economics of Strategy
Slide show adapted on the basis of that prepared by
Richard PonArulCalifornia State University, Chico
© John Wiley & Sons, Inc.
Chapter 3
Vertical Boundaries of the Firm
Besanko, Dranove, Shanley and Schaefer, 3rd Edition
Vertical Chain
Begins with the acquisition of raw materialsEnds with the sale of finished goods/servicesIncludes support services such as Finance and MarketingOrganizing the vertical chain is an important part of business strategy
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)
Vertically Integrated Firms
In a vertically integrated firm, many of the steps in the vertical chain are performed in-house. Example: Scott PaperSome firms choose to outsource many of the vertical chain tasks and become vertically disintegrated. Example: Nike
Make versus Buy
Decision depends on the costs and benefits of using the market as opposed to performing the task in-houseOutside specialists may perform a task better than the firm canIntermediate solutions are possible (Examples: Strategic alliances with suppliers, Joint ventures)
Support Services
AccountingFinanceLegal SupportMarketingPlanningHuman Resource Management
Support Services
Support services can be major sources of value creation– UPS – Logistics– Toyota – Human Resource Manager– Nike - Marketing
Some Make-or-Buy Fallacies
Firm should make rather than buy assets that provide competitive advantagesOutsourcing an activity eliminates the cost of that activityBackward integration captures the profit margin of the supplierBackward integration insures against the risk of high input pricesIt makes sense to tie up the distribution channel in order to deny access to the rivals
Make-or-Buy and Competitive Advantage
A firm believes that a particular asset is a source of competitive advantageIt turns out the asset is easily available in the marketThe belief regarding competitive advantage will have to be reevaluated
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
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 borneIf the supplier is earning economic profit, what is the reason for its persistence? Market competition should eventually erode away the economic profit
Vertical Integration and Input Price Risk
Instead of vertical integration, forward or futures contracts can be used to hedge input price riskAnother possibility is that the capital tied up in vertical integration could be used to set up a self insurance fundVertical integration into a risky activity will add rather than reduce the overall risk
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 valueIn either case, economic profits do not flow form the foreclosure of distribution channels
Benefits of Using the Market
Market firms (outside specialists) may have patents/proprietary information that makes low cost production possibleMarket firms can achieve economies of scale that in-house units cannotMarket 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)
Economies of Scale
Economies of Scale
A given manufacturer of automobiles may not be able to reach the minimum efficient scale (A*) for anti-lock brakesAn outside supplier may reach the minimum efficient scale by supplying to different automobile manufacturers
Economies of Scale
An automobile manufacturer would rather buy anti-lock brakes from an independent supplier than from a competitorMinimum efficient scale may be feasible for the independent supplier but not for an automobile manufacturer
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
Make-or-Buy in Insurance
Buying insurance utilizes economies of scale available to insurersLarge firms with sufficient capital can “self-insure”
Self-Insurance by British Petroleum
BP self-insures large losses but buys insurance for small lossesInsurers bring in specialized expertise to handle small losses (learning curve)
Agency and Influence Costs
The incentives to be efficient and innovative are weaker when a task is performed in-houseAgency costs are particularly problematic if the task is performed by a “cost center” within an organizationIt is difficult to internally replicate the incentives faced by market firms
Influence costs
In addition to agency costs, performing a task in-house will lead to “influence costs” as well“Internal Capital Markets” allocates scarce capitalAllocations can be favorably affected by influence activitiesResources consumed by influence activities represent “influence costs”
Problems in Using the Market
Costs imposed by poor coordinationReluctance of partners to share valuable private informationTransactions cost that can be avoided by performing the task in-house
Each problem can be traced to difficulties in contracting
Role of Contracts
Firms often use contracts when certain tasks are performed outside the firmContracts list– the set of tasks that need to be performed – the remedies if one party fails to fulfill its obligation
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
Complete Contract
A complete contract stipulates what each party should do for every possible contingency. No party can exploit others’ weaknessesTo create a compete contract one should be able to contemplate all possible contingenciesOne should be able to “map” from each possible contingency to a set of actionsOne should be able to define and measure performancesOne should be able to enforce the contract
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
Incomplete Contracts
Incomplete contracts– Involve some ambiguities– Need not anticipate all possible contingencies– Do not spell out rights and responsibilities of parties
completely
Factors that Prevent Complete Contracting
Bounded rationalityDifficulties in specifying/measuring performanceAsymmetric information
Bounded Rationality
Individuals have limited capacity to– Process information– Deal with complexity– Pursue rational aims
Individuals cannot foresee all possible contingencies
Specifying/Measuring Performance
Terms like “normal wear and tear” may have different interpretationsPerformance cannot always be measured unambiguously
Asymmetric Information
Parties to the contract may not have equal access to contract-relevant informationOne party can misrepresent information with impurity
Contract Law
Contract law facilitates transactions with incomplete contractsParties need not specify provisions that are common to a wide class of transactions
Limitations of Contract Law
Doctrines of contract law are in broad language that could be interpreted in different waysLitigation can be a costly way to deal with breach of contract– Litigation can be time consuming– Litigation weakens the business relationship
Coordination of Production Flows
For successful coordination one party needs to make decisions that depend on the decision made by othersA good fit should be accomplished in several dimensions– Timing– Size– Color– Sequence– R & D
Coordination Problems
Without good coordination, bottlenecks arise in the vertical chainCoordination is especially important when “design attributes” are presentTo ensure coordination, firms rely on contracts that specify delivery dates, design tolerances and other performance targets
Design Attributes
Design attributes are attributes that need to relate to each other precisely; else significant loss in economic value resultsSome examples– Sequencing of courses in MBA curriculum– Fit of auto sunroof glass to aperture– Timely delivery of a critical component
Design Attributes
If coordination is critical, administration control may replace the market mechanismDesign attributes may be moved in-house
Leakage of Private Information
Firms would not want to compromise the source of their competitive advantage, hence some activities cannot be out-sourcedSometimes, contracts can be used to protect against leakage of critical information(Example: Non-compete clause for employees)
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
Transactions Costs
Out-sourcing entail costs of negotiating, writing and enforcing contractsCosts are incurred due to opportunistic behavior of parties to the contract and efforts to prevent such behaviorTransactions costs explain why economic activities occur outside the price system
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)
Relationship-Specific Assets
Relation-specific assets are essential for a given transactionThese assets cannot be redeployed for another transaction costlesslyOnce 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
Relationship-Specific Assets: Examples
An aluminum refiner invests in a refinery designed to process a particular grade of bauxite oreThe French government invests in transportation infrastructure for Euro-Disney
Forms of Asset Specificity
Relation-specific assets may exhibit different forms of specificity– Site specificity– Physical asset specificity– Dedicated assets– Human asset specificity
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
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
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
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
Rent and Quasi-rent
The term ‘rent” denotes economic profits –profits after all the economic costs, including the cost of capital, are deductedQuasi-rent is the excess economic profit from a transaction compared with economic profits available form an alternate transaction
Rent and Quasi-rent
Firm A makes an investment to produce a component for Firm B after B as agreed to buy from A at a certain priceAt that price A can earn an economic profit of π1
If A were to renege on the agreement and B is forced to sell its output in the open market, the economic profit will be π2
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)
The Holdup Problem
Whenever π1 > π2, Firm B can benefit by holding up A and capturing the quasi-rent for itselfA complete contract will not permit the breachWith incomplete contracts and relationship-specific assets, quasi-rent may exist and lead to the holdup problem
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
Holdup and Contract Negotiations
When there is potential for holdup, contract negotiations become tedious as each party attempts to build in protections for itselfTemptations on the part of either party to holdup can lead to frequent renegotiationsThere could be costly disruptions in the exchange
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
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
Holdup and Underinvestment
When there is a holdup, the investment made in relationship-specific assets loses valueAnticipating holdups, firms will make otherwise sub-optimal level of investments and suffer higher production costs
Asset Specificity and Transactions Costs
Relation-specific assets support a particular transactionRedeploying to other uses is costlyQuasi rents become available to one party and there is incentive for a holdupPotential for holdups lead to– Underinvestment in these assets– Investment in safeguards– Reduced trust
Recap
Relationship-Specific AssetsRelationship-Specific Assets
Quasi-RentsQuasi-Rents
Holdup ProblemHoldup Problem
Transactions CostsTransactions Costs
Transactions Costs and Vertical Integration
Vertical integration (VI) is an alternative to market contractsWhy should VI reduce the holdup problem?
– differences in governance– repeated relationship– organizational influences
Differences in governance
Powerful and flexible systems exist inside firms to resolve disputesLess formal contracting and more formal authority
– management fiat– formal lines of control
Information is more extensive since it is internal– reduces problems of bounded rationality and hidden
information
Repeated relationship
Vertical relationship involves trading parties in a repeated relationship
– less incentive for opportunistic behaviorknow that the relationship will continue
– more incentive to make relationship-specific investmenttemptation to holdup is reduced
But not the only possibility:– long-term contracting can achieve the same benefits
Organizational influences
Common purpose across divisionsCreation of corporate culture
– teamwork– information sharing
Competition between divisions still exists– adversarial relationships– competition for advancement
Senior management needs to balance competition and cooperation between divisions