vertical integration 2
TRANSCRIPT
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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