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