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Lecture 6
Sources and Limits of Value Creation
in Vertical Mergers
Dr. Sangeeta Yadav
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What are the vertical boundariesof a firm?
What are Make or Buy-decisionsand what
factorshave to be considered?
What is the trade-off in vertical integration,I.e. in MoB (Make or Buy)-decisions?
Are there alternatives to the complete
internalisation and externalisation of activities?
Learning outcomes
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Entering New Industries to strengthen the
core business model
Vertical integration is a corporate level strategy.
It improves the competitive position of firm and
strengthen the business model.
Vertical integration- a multi business model-afirm enters new industries to support its core
industry (primary source of its competitive
advantage and profitability).
This multi business model is to add value to iits
core products- increases product differentiation
and/or lowers cost structure.
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Vertical Integration
Backward integration-expansion into an
operation that produces inputs for the companys
products
Forward integration-expansion into an industrythat uses, distributes or sells companys
products.
Vertical Integration- either through organic
growth- or through merger/acquisition.
E.g steel company, PC maker, Apple computers,
Dell, IBM.
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Value Chain Porter
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Vertical Chain Production of furniture
Raw Inputs: Tree, Iron
Retailers: Furniture Stores
Intermediate Goods Preprocessors
(e.g. Metalworking Shops)
Assemblers: FurnitureManufacturers
Transportationand Warehousing
Support ServicesProcessing and handling
Transportationand Warehousing
AccountingFinanceHRMLegal SupportMarketingPlanning
Other Support Services
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Value Chain
At each stage value is added to the product-
each stage of value added chain is a separate
industry or industries in which many different
companies my be competing. Every company has a value chain- value
creation activities like R&D, production,
marketing, customer service etc.
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Decide which steps of the value added chain areto be performed inside the firm and which to beout-sourced (Make or Buy)
Vertically integrated/disintegrated firms
Intermediate solutions are possible. Examples:
Strategic alliances with suppliers, Jointventures
Vertical Boundaries of the Firm
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Benefits of buying from market
Cheapest supplier if market is competitive
Supplier is able to reap economies of scale and
learning economies
Increasing division of labour and specialisation
Motivated to enhance efficiency
Supplier has high incentive to keep up with new
technology Avoids internal coordination costs
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Costs of buying from market
Quality and delivery uncertainty
Suppliers products if branded, too costly
Suppliers of specialized products very few and
hence costly
Problems in coordinating production flows
Leakage of private information to supplier and to
possibly rivals Transaction costs high relative to internal
production
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Solution lies in long term contracts
Long term contracts
Benefits of contracts gives supplier incentive to make specific investment, to keep
up with technology, allows closer coordination, risk indisposal of residual assets rests with supplier
Costs of Contracts Incomplete contracts, suppliers opportunism (due to asset
specificity), costs of monitoring performance, costs of
contract enforcement and dispute resolution
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Benefits of Vertical Integration
Facilitates investment in specialized assets A specialized asset (site specific, physical characteristics
specific, dedicated assets, human specific)is one that is
designed to perform a specific task and whose value is
reduced in its next best use- could be a piece of equipment,know how or employee skills
Company invests in specialized assets to lower
manufacturing product and to improve quality of product.
If company buys from market then the supplier needs to
invest in specialized assets. But it is difficult to convinceoutsider to invest in specialized asset-creates dependency of
supplier for business-this puts buyer in a strong bargaining
positionso supplier declines to invest in a specialized asset.
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Benefits of Vertical Integration
Buyer also considers that getting the specialized asset from
an independent supplier creates dependency on supplier.
This creates a situation of mutual dependence leads to hold
up problem (that is each party can take advantage once the
investment in specialized asset is made)leads to lack of
trust amongst the two so only way out is to go for VI rather
than market transaction.
E.g. automobile companies have historically integrated
backwards to make component parts, steel into production of
iron, computers into chip production ,aluminum companies
into bauxite production due to hold-up problem.
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Benefits of Vertical Integration
Enhancing product quality General Mills backward integration into banana plantations
In 1920s Kodaks forward integration into retail outlets for
distributing photographic equipment, in 1930 they withdrew
since good retailers were available by then.
Better co-ordination and scheduling Leads to quicker, easier and more cost effective planning, co-
ordination, scheduling and transfer of product possible.
Just in time inventory systems Allows better response to sudden changes in demand
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Benefits of Vertical Integration
Control over key raw material
sensitive private information protected
Some transactions costs avoided by
performing the task in-house
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Market firms can achieve economies of scale
and learning economies that in-house units
cannot (specialization)
Market firms are subject to market discipline. In-house units may be able to hide their
inefficiencies behind overall corporate success
(Agency and influence costs).
Disadvantages of Vertical Integration
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The incentives to be efficient and innovativeare weaker when a task is performed in-house -
It is difficult to internally replicate the incentives
faced by market firms. Internal Capital Markets allocates scarce
capital. Allocations can be favorably affected by
influence activities - Resources consumed by
influenceactivities represent influence costs.
Agency and Influence Costs
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Higher costs due to Failure to achieve maximum economies of scale
Captive buying and selling within the divisions of firm
Higher administrative and agency costs.
Limited Marketing reach- which holds back sales
and profit potential
Exposure to Cyclical and Secular downturns.
Disadvantages of Vertical Integration
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Using the market improves technical efficiency(least cost production)
Vertical integration improves agency efficiency
(coordination, transactions costs) Firm should economize - choose the bestpossible combination of technical and agencyefficiencies
Tradeoff in Vertical Integration
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The combined (market over vertical integration)
differential efficiency will be negatively related to
asset specificity
At high levels of assets specificity verticalintegration is more efficient
At low levels of assets specificity outsourcing
wins
Efficiency Tradeoff
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Inputs in the form of routine products and
services are likely to be procured in the market
(suppliers economies of scale)
When a firms product market activities is large inscale, it is likely to be vertically integrated
Presence of relationship-specific assets will tilt
the advantage in favor of vertical integration
Conclusions From the
Efficiency Tradeoff Model
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Tapered integration (making some and buying
the rest)
Joint ventures and strategic alliances
Long term collaborative relationships
Implicit contracts between firms
Alternatives to Vertical Integration
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Thank You!
Dr. Sangeeta Yadav