Chapter 2 Firms and Markets

School of Economics and Business Administration

Universidad de Navarra

Recall: 12th of April midterm exam (elective)

6 points. Concepts. Revise the theories of vertical and horizontal integrations.

4 points. Exercise: Specific assets, holdup and vertical integration.

Economics of organizations

Structure of the chapter

2.1. Efficiency and limits of the market

2.2. Transaction Costs and the holdup problem

2.3. Behavioral approach to the holdup problem

2.4. Vertical and Horizontal Boundaries of the Firm

Long term contract and implicit contract- An implicit contract is an tacit and informal

agreement that does not appear in any legally enforceable document.

- In that case, parties may decide to write long term contracts to sustain agreements that are not legally enforceable. It is possible given that one party can threaten the other with future punishments in case of no compliance of the initial agreement.

2.4. Vertical boundaries of the firm Alternatives to vertical integration

Business alliances- In a business alliance, several firms agree to collaborate

in a project and exchange information and other inputs (General Motors – Toyota in the 80s).

- Similar to market transactions as firms are independent entities, but a business alliance implies a greater level of cooperation, coordination and information transmission than in a market transaction making the alliance closer to a situation of vertical integration.

2.4. Vertical boundaries of the firm Alternatives to vertical integration

FranchisingIn a franchise agreement, the franchisee operates a business using the brand of a franchisor and frequently buys inputs or final products to the franchisor.Examples: Fast food (McDonalds, Burger King, Telepizza). Automobile industry (car dealerships).The payment scheme is usually a fixed payment plus a percentage of sales.

- It is not a case of vertical integration since the franchisee is not the employee of the franchisor.

- Franchising implies holdup problems and agency costs.

2.4. Vertical boundaries of the firm Alternatives to vertical integration

Franchising puzzleFranchising among gas stations that provide repair services is more frequent that for gas stations that do not.

Why?

2.4. Vertical boundaries of the firm Alternatives to vertical integration

Definition: a production process exhibits economies of scale over a range of output if the average cost decreases in this range of production levels.

2.5. Horizontal boundaries of the firm Economies of scale

Q

AC(Q)Average

cost function

Q* Optimal sizeof the firm

a

Definition: There are economies of scope if a single firm producing two goods X and Y has a lower average cost than two separate firms, each producing one of the goods.

2.5. Horizontal boundaries of the firm Economies of scope

Economies of scale and scope appear because of the existence of fixed costs that are divided into a larger number of units as the volume of production increases.

1. Indivisibilities. (e.g. Transport).

2. Access to an efficient technology. (e.g. Machinery).

3. Stocks and uncertainty. (e.g. Seller out of stocks).

2.5. Horizontal boundaries of the firm Sources of economies of scale and scope

4. Research and development costs (e.g. Pharmaceutical industry)

5. Purchasing and bargaining power.

6. Publicity expenses (e.g. Sony)

2.5. Horizontal boundaries of the firm Sources of economies of scale and scope

1. Labor costs. (Empirical evidence).

2. Incentives and bureaucracy. (Coordination and motivation costs).

3. Non-replicability of entrepreneurial talent. (Coase 1937).

4. Legal motives.

2.5. Horizontal boundaries of the firm Sources of diseconomies of scale and scope

Description of the case: managing synergies.- System One is a firm controlled by Continental Airlines

that operates the system of electronic reservations and other information.

- System One deals with 20% of the total reservations of US Airline Companies.

- Until 1991, System One is also a data provider to 170 airline companies.

- a) Why airline companies do not operate their own reservation service?

Firm boundariesCase I: EDS – Continental Airlines

In 1991, the firm Electronic Data Service takes the control of System One.

- Electronic Data Service is a leading provider of information services in the banking and energy sectors.

- b) Do you think taking the control of System One is profitable operation for Electronic Data Service? Why?

Firm boundaries Case I: EDS – Continental Airlines

Description of the case: managing incentives.- Rolm is a small firm in the Sillicon Valley with rapid

growth in the computer sector (computers, information systems.).

- Rolm has a very peculiar corporate culture: “no dressing codes no time schedules”. However, employees work a lot.

- To maintain the corporate culture: a large number of small divisions and employees in Rolms’ stocks.

- Rolm compete with giants like AT&T y Northern Telecom.

Firm boundaries Case II: Rolm - IBM

The management of Rolm decides to ask for the support of IBM by giving IBM the possibility to take the control of Rolm with the restriction of not modifying the management style of Rolm.

Do you think taking the control of Rolm is a good decision for IBM?

Firm boundaries Case II: Rolm - IBM

Do you think taking the control of Rolm is a good decision for IBM?- Problem: conflicting sales strategies between the two firms. Price differentiation impossible for IBM. Less flexibility for Rolm’s employees implying lower commissions. Many salespersons decided to leave the integrated firm. - System of incentives such that Rolm’s paid with IBM stocks.- In 1986 most executives left the firm.- In 1988 IBM sold Rolm.

Firm boundaries Case II: Rolm - IBM

Description of the case: profit sharing.- In 1984, General Motors takes the control of Electronic

Data Service (EDS), a firm of information services.- The success of EDS depends crucially on the motivation of

its salespersons paid bonuses in stock options.- General Motors wants to acquire EDS to improve its

information services and then its production technology.

What do you think about the decision of General Motors?

Firm boundaries Case III: General Motors - EDS

- GM commits to maintain the management style of EDS paying employees of EDS with stock options of EDS that GM decided to maintain as a special class of actions of GM.

- In 1985, EDS profits increased by 400%.

What is the potential problem?

Firm boundaries Case III: General Motors - EDS

- A study by the University of Ohio State assesses the failure of mergers to 60%.

a) How should we measure the success of a merger?

Firm boundaries Mergers or myths

a) How should we measure the success of a merger?Example AOL – Time Warner

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Firm boundaries Mergers or myths

- A study by the University of Ohio State assesses the failure of mergers to 60%.

b) Why do mergers fail? - Report by McKinsey:

“Too much attention has been devoted to financial and legal aspects of mergers but it is well recognized that the crucial element for the success of a merger is the human resource management”.

Firm boundaries Mergers or myths

b) Why do mergers fail?

1. The human factor and the integration of employees. Managing corporate cultures conflicts.

2. Power conflicts.

3. Loss of talent (loss of control, uncertainty).- American Management Association: 47% of the senior executives leave the firm in the year of the merger. - Wall Street Journal: 50-75% of the executives think to leave the integrated firm within 3 years after the merger.

4. Loss of customers.

Firm boundaries Mergers or myths

b) Why do mergers fail?

5. Executives usually overestimate the potential synergies associated to mergers, overconfidence (Synergies?).

6. Prestige and high salaries of top executives.

Firm boundaries Mergers or myths