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    Vertical integration

    When doesoutsourcing/ownership matter?

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    What is vertical integration?

    Vertical (or horizontal) integration means thatthe assets that were previously held by twofirms are combined into a single firm.

    The result is either joint ownership or the saleof one firms assets to the other.

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    Market Imperfections

    Upstream and downstream firm

    Downstream firm

    Monopolist with no costs Sets price to its market (mark-up over marginal

    costs)

    Upstream firm

    Monopolist

    Sets input price to downstream firm anticipatingimpact on demand

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    Vertical Integration

    Suppose upstream and downstream firms arecommonly owned

    Best internal transfer price is based onupstream marginal cost, c.

    Market price set so that MR = c.

    Maximises joint profits

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    Impact on Profits

    DownstreamProfit

    $

    PI

    QI

    c

    Marginal Demand

    c + t

    Joint Marginal

    Downstream Marginal

    QS

    PS

    Upstream

    Profit

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    Double Marginalisation

    With outsourcing

    Both firms charge a mark-up

    Higher prices, low overall profits, lower consumerwelfare (not very competitive if there is anothervertical chain)

    Solved by:

    Vertical integration Two-part tariffs

    More downstream or upstream competition

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    Can vertical integrationmatter?

    The Coase Theorem tells us that asset ownershipdoes not matter for efficiency.

    Assumes complete contracting

    When contracts are incomplete there exist residualrights of control (unspecified actions). According toGrossman & Hart:

    To the extent that there are benefits of control, there will

    always be potential costs associated with removing control(i.e., ownership) from those who manage productiveactivities.

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    GM-Fisher Body

    1920s: General Motors purchased car bodies fromindependent firm (Fisher Body)

    Technology change: wooden to metal

    GM built a new assembly plant that required reliablesupply

    wanted Fisher Body to build a new car body plant next to it

    no need for shipping docks etc.

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    Fisher Refused

    Fisher Body refused to make this investment.

    Feared that a plant so closely tailored toGMs needs would be vulnerable to GMs

    demands (hold-up) Eventually resolved this issue by vertical

    integration -- could not find a contractualsolution

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    Merger Benefits & Costs

    Benefits to GM:

    Could make more demands of Fisher Body

    More investment or extra supply

    Costs to GM: Diminished managerial incentives

    If costs are lowered in the body plant, GM is better able toappropriate these at expense of managers.

    Harder to keep those costs down.

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    Bottling Pepsi

    PepsiCo has two types of bottlers:

    Independent: owns assets of bottling operationand exclusive rights to franchise territory. Can

    determine how these are used - when to restockstores etc.

    Company owned: decisions can be made higherup; Pepsi can choose to delegate local marketingto its subsiduary

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    Pepsis Control

    Pepsi cannot control how an independent bottleroperates in a territory If it wants a national marketing strategy (such as the Pepsi

    Challenge), it cant compel the bottler to cooperate

    By acquiring a bottler, Pepsi has ultimate control. If the subsidiary managers refused to participate in the

    national campaign, they could be sacked and replaced.

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    Motivating Example Again

    Service requires a truck (the asset) for production

    Also, enhancing value are:

    a shipper, S (who wants to ship goods) there are also other shippers except that they have goods to ship that

    are $100 less in value created a trucker, T (does this): can take care or no care in maintaining

    truck; there are many truckers who can take no care but this particular

    trucker is the only one that can take care

    Effort in care is relationship-specific and is now assumed to benon-contractible

    Also assume that care is a skill that is developed (through habitsetc.). Therefore, it becomes embedded in the truckers humancapital.

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    Effort and Value

    Benefit from extended truck life

    No Care: trucks value is $50

    Care: trucks value is $200

    Truckers effort cost of care Minimal care: cost of $0

    High care: cost of $100

    Marginal Benefit = $150> $100 = Marginal Cost

    Efficient to take care

    What happens under different ownership structures forthe asset?

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    Non-contractible Investment

    Suppose bargaining took place after effort choice ismade

    There are four cases to evaluate.

    Minimal care and alternative shipper Minimal care and S

    High care and alternative shipper

    High care and S

    S is no longer essential and so their added value isless than the T if they do not own theasset.

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    Will trucker take care?

    OwnershipStructure

    ShippersAdded Value

    (ExpectedSurplus)

    TruckersAdded Value

    (ExpectedSurplus

    3rd PartysAdded Value

    (ExpectedSurplus)

    BackwardIntegration

    $200($125)

    $150($75)

    $0($0)

    Forward

    Integration

    $100

    ($50)

    $200

    ($150)

    $0

    ($0)Cooperative $200

    ($100)$200($100)

    $0($0)

    VerticalSeparation

    $100($16.66)

    $150($66.66)

    $200($116.66)

    Ex Post Added Values: How to Share $200

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    Incentives and Ownership

    Trucker can be easily replaced if does not take care.However, under BI and 3rd party ownership (verticalseparation), does not expect to earn enough tocover costs of $100.

    Will take care under FI: needs to have control rights(i.e., right to exclude use of asset) in order to gainsufficient surplus ex post. That is, under FI, by taking care, T gets $50 (=$150-$100)

    but only $25 if it does not take care.

    Under Cooperative, taking care gives T $0 but not takingcare gives them $25.

    General principle: give control rights to agentsmaking important investments.

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    Efficient Integration Level

    As they encourage the trucker to take care,forward integration is the only efficientorganisational form

    Do we expect asset ownership to trackefficiency?

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    Shipper Interests

    Shipper might choose to have a back haul. Aback haul adds value of $100 (independent oflevel of care).

    Suppose that trucker if they own the truckcan find alternative customers for the backhaul. If expend cost of $10 will find alternative

    customer adding value of $50.

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    Forward Integration

    Shippers added value ex post: $250 if trucker searches for alternative customer

    $300 if trucker does not search

    Truckers added value ex post $300 regardless of whether searches

    Searching improves truckers expected surplusfrom $150 to $175; therefore, worth the $10expense.

    If search very costly, BI may become efficientagain.

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    Optimal Firm Boundaries

    Ownership provides maximal incentives totake non-contractible actions

    Optimal firm boundary depends upon: whose actions are hardest to encourage whose actions are most important for value

    Never vest ownership with someone who

    does not provide a non-contractible action(I.e., 3rd party)

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    What Happens in Trucking?

    Suppose that you could put on-boardcomputers on truckers to monitor drivers.

    Theory: easier to monitor drivers care and

    reflect it in explicit performance payments orfines therefore, less need for truckerownership.

    Baker & Hubbard (2000): use of OBCs hasincreased non-trucker ownership especiallyon routes that may be more subject to truckerrent seeking.

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    Shipper vs. Carrier ownership

    What determines whether shippers use internal (captive) fleets orfor-hire carriers for a haul?

    Determines who owns control rights associated with dispatch(truck scheduling)

    Shippers use internal fleets when want high service levels fromtruck drivers

    Truck utilisation higher in for-hire fleets ability to line up asequence of hauls for a truck tight coordination (requiresdispatcher effort)

    Need for flexibility conflicts with search for back hauls Harder to motivate truck drivers when looking for high service

    levels.

    Empirically: OBCs lead to more shipper ownership

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    Case: Insurance Industry

    Insurance industries

    In-house sales force: whole life

    Independent brokers: fire and casualty

    Choice determines ownership of client list

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    Effect of ownership

    Agent owns list

    cannot be solicited without permission

    agent looks for clients most likely to renew

    motivate agents by using renewal commission agent can hold-up company; threaten not to introduce new

    products to clients

    Company owns list

    company can hold-up agent; threaten to increasepremiums that reduce renewal commission

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    Applying Grossman & Hart

    Choice between independent and in-house agentsshould turn on relative importance of investments indeveloping long-term clients by the agent and list-building activities of the insurance firm Whole life: customer less likely to switch so searching for

    long-term customers less important -- in-house

    Fire & casualty: searching for long-term customers isimportant -- independent

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    Dynamic Issues

    How does outsourcing andintegration performance change

    over time?

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    T5 at Heathrow

    Project management handled internally

    Contractors on cost-plus contracts (not fixedprice as is usually the case)

    British Airports Authority wanted to keepoptions open to change design specificationsthroughout the life of the project

    Happy to engage in on-going managerialattention

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    Fixed vs Cost Plus

    Fixed contracts

    Costs arent passed through

    High powered incentives to keep costs down

    Anticipate cost savings that might be achieved when tendering

    But contracts incomplete: so subject to renegotiation (alsoanticipated in tender)

    Cost plus contracts

    Costs are passed through

    Low powered incentives

    No difficult renegotiations easier to change designs duringproject

    For complex projects that require lots of coordination, may bebetter to use cost plus contracts

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    Car Manufacturing

    Varied patterns of outsourcing

    Some companies integrated (GM)

    Some outsource almost everything (Volvo)

    Novak-Stern case studies suggest that... External sourcing allows firms to access state-of-the-art

    technology but leaves them open to hold-up and low effort supplyafter the initial terms of the contract are satisfied

    Internal development is associated with inferior technology

    development and high costs for an initial model-year, but thereare much greater opportunities for improvements over time

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    Performance Over time

    Vertical Integration External Sourcing

    Ex AnteContracting

    Opportunities

    Deep vehicle- specific

    knowledge base Less knowledge ofsystem-specific technology Difficult to enforce specificperformance criterion

    Global supply opportunities

    Opportunity for well-defined performancecontracts

    Ex PostRenegotiation Outcomes

    Continuing authority

    relationship allows forredirection Potential for learning

    Hard to enforce contracts

    after key requirements havebeen met Fewer continuingrelationships

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    Empirical Findings

    Model Year

    Performance(Consumer Reports)

    Internal Sourcing

    Outsourcing

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    Summary

    No black and white choice in outsourcing

    Capabilities can improve over time

    Ability to coordinate internal or external teams

    Ability to improve internal performance

    Handling contractual disputes

    No one size fits all

    Complexity design and parts

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    Principles of EfficientOwnership

    Simple example

    Asset: luxury yacht

    Service: gourmet seafare

    Workers: chef and skipper Customer: tycoon

    Value created

    Tycoon value = $240 (no other customers)

    Substitutes for skippers skills (no added value)

    Chef: asset-specific action (no other yachts) for cost of $100;necessary to provide service for Tycoon

    Time-line

    Date 0: chef chooses whether to take action

    Date 1: negotiate over division of $240

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    Ownership Outcomes

    Owner Skipper Tycoon Chef

    Division

    (S, T, C)240/3 each 0, 240/2, 240/2 0, 240/2, 240/2

    Invest No Yes Yes

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    Skipper Value

    Now suppose, skipper has a non-contractible(date 0) action

    for cost of $100 can increase value of service to

    tycoon by another $240 (total now $480)

    for example, increases knowledge of local islands

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    Ownership Outcomes

    Owner Skipper Tycoon Chef

    Division

    (S, T, C)200, 200, 80 120, 240, 120 80, 200, 200

    Invest No Yes Yes

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    Complementary Assets

    Now suppose there are other customerswho can use the yacht

    But tycoon can choose a non-contractibleaction (e.g., plan entertainment schedulefor the year). Gives additional value of$240.

    Yacht can be split in two: galley and hull

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    Divided Ownership

    Is it ever optimal for chef to own galley andskipper to own hull? Division of value is: chef ($320), skipper ($320)

    and tycoon ($240/3) Tycoon has to reach agreement with both while

    skipper and chef only require their joint agreement

    Better to give entire yacht to skipper or chef.

    Tycoons incentive rises ($240/2)

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    Principles

    Never give ownership to dispensableindividuals

    Give ownership to indispensable agents(even though may not make an investment)

    Vest ownership of complementary assetswith a single individual

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    Qualification

    Does asset ownership really improve incentives forspecific investments?

    Those investments create value But may reduce the assets value outside of the

    relationship: it is specialised to the other agent

    Without ownership, do not care about this reduction

    Hence, it is possible that incentives could be reduced byownership

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    Summary

    Value of ownership

    Increased bargaining position (added value)

    Incentives to take non-contractible actions

    Ownership improves this by allowing agent to capture agreater share of the rewards

    But diminishes the incentives of non-owners

    Who shouldown an asset?

    Agents taking non-contractible actions Important agents