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VERTICAL INTEGRATION

The Vertical Boundaries of the Firm

• Begins with the acquisition of raw materials

• Ends with the sale of finished goods/services

• Includes support services such as Finance and Marketing

• Organizing the vertical chain is an important part of business strategy

Vertical boundaries

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Vertical Chain of Production

Support services are provided all

along the chain Early steps in the

production process are

upstream (Timber for furniture)

Later steps are downstream

(finished goods in

showrooms)

Vertically Integrated Firms

• Some firms choose to outsource many of

the vertical chain tasks and become vertically disintegrated. • Example: Nike

• Some perform all the tasks in the vertical

chain in-house. • Example: Scott Paper

WHY?????

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Vertical Boundaries of the Firm

•Vertical boundaries of the firm demarcate which tasks in the vertical chain are to be performed inside the firm and which to be out-sourced. •The choice is between the market and the organization is a make or buy decision.

…a continuum of possibilities between the two extremes

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Defining Boundaries

•Firms need to define their vertical boundaries.

•Outside specialists who can perform vertical chain tasks are market firms.

• Market firms are often recognized leaders in their field

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Market Firms

•Benefits of using market firms • Economies of scale achieved by market firms • Value of market discipline

•Costs

• Problems in coordination of production flows • Possible leak of private information • Transactions costs

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Some Make-or-Buy Statements

1. Outsourcing an activity eliminates the cost of that activity

2. Making instead of buying captures the profit margin of the market firms

3. Vertical integration insures against the risk of high input prices

4. Making ties up the distribution channel and denies access to the rivals

Make versus Buy

• Decision depends on the costs and benefits of using the market as opposed to performing the task in-house.

• Outside specialists may perform a task better than the firm can.

• Intermediate solutions are possible. • Examples: Strategic alliances with suppliers, Joint

ventures

Benefits and Costs of Using the Market

A. Benefits of using the market B. Costs of using the market

A1. Economies of Scale and Learning Economies (TANGIBLE)

A2. Agency and Influence Costs (INTANGIBLE)

B1. Coordination Problems B2. Leakage of Private

Information B3. Transactions Costs

A1. Economies of Scale

• A given manufacturer of automobiles may not be able to reach the minimum efficient scale (A*) for anti-lock brakes.

• An outside supplier may reach the minimum efficient scale by supplying to different automobile manufacturers.

A2. Agency and Influence Costs

• The incentives to be efficient and innovative are weaker when a task is performed in-house. WHY?

• Agency costs are particularly problematic if the task is performed by a “cost center” within an organization.

• It is difficult to internally replicate the incentives faced by market firms.

A2. Agency Costs

• To create market-like incentives, managers could be given incentive-based pay.

• Incentive-based pay will increase the risk exposure for the managers and lead them to demand higher base level compensation.

• Internal mechanisms for promoting innovation often do not work.

Promoting Innovation Internally

• It may be difficult to evaluate proposals to do innovative work.

• Basing the reward on easy-to-measure dimensions may result in sub-optimal choices.

• Example: Incentives based on the number of new products each year will shift the efforts towards short-term, incremental innovations.

A2. Influence costs

• In addition to agency costs, performing a task in-house will lead to “influence costs” as well.

• “Internal Capital Markets” allocates scarce capital. Allocations can be favorably affected by influence activities.

• Resources consumed by influence activities represent “influence costs.”

B) Costs of Using the Market

• Coordination of production flows through the vertical chain may be compromised.

• It may be difficult to protect sensitive private information.

• Some transactions costs could be avoided by performing the task in-house.

B1. Coordination Problems

• Some examples: – If the supplier does not deliver certain parts on schedule,

the factory may have to be shut down. – Lack of coordination in advertising images in local

markets can undermine the value of the brand. – Unexpected cancellation of a course by a foreign

university may delay the graduation of exchange students.

B2. Leakage of Private Information

• Firms would not want to compromise the source of their competitive advantage. Hence some activities cannot be out-sourced.

• Sometimes, contracts can be used to protect against leakage of critical information. Example: Non-compete clause for employees

B3. Transactions Costs

• Out-sourcing entail costs of negotiating, writing and enforcing contracts.

• Costs are incurred due to opportunistic behavior of parties to the contract and efforts to prevent such behavior.

• Transactions costs explain why economic activities occur outside the price system.

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Sources of transactions Costs

•Sources of transactions costs: • Investments that need to be made in relationship specific

assets • Possible opportunistic behavior after the investment is made

(holdup problem) • Quasi-rents (magnitude of the holdup problems)

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Relationship-Specific Assets

•Relation-specific assets are assets essential for a given transaction • These assets cannot be redeployed for another transaction without

cost • Once the asset is in place, the other party to the contract cannot be

replaced without cost, because the parties are locked into the relationship to some degree

•Relation-specific assets may exhibit different forms of specificity • Site specificity • Physical asset specificity • Dedicated assets • Human asset specificity

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Fundamental Transformation

•Prior to the investment in relationship specific assets there are many trading partners. •Once the investment is made the situation becomes a bargaining situation with a small number partners

•Relationship specific assets cause a fundamental transformation in the relationship

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Rents and Quasi-Rents

•The term rent denotes economic profits – profits after all the economic costs, including the cost of capital, are deducted

•Quasi-rent is the excess economic profit from a transaction compared with economic profits available from an alternate transaction

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Rents and Quasi-Rents

•Firm A makes an investment to produce a component for Firm B after B as agreed to buy from A at a certain price

• At that price A can earn an economic profit of πA

• If B were to renege on the agreement and A is forced to sell its output in the open market, the economic profit will be πB

•Rent is the minimum economic profit needed to induce A to enter into this agreement with B (πA) •Quasi-rent is the economic profit in excess on the minimum needed to retain A in the selling relationship with B (πA- πB)

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•Whenever positive quasi rent Firm B can benefit by holding up A and capturing the quasi-rent for itself

• A complete contract will not permit the breach. • With incomplete contracts and relationship-specific assets, quasi-

rent may exist and lead to the holdup problem

The Holdup Problem

Organizing Vertical Boundaries

The Tradeoff in Vertical Integration

• Using the market improves technical efficiency (least cost production)

• Vertical integration improves agency efficiency (coordination, transactions costs)

• Firm should “economize” - choose the best possible combination of technical and agency efficiencies

• Assumption: Q=fixed

Technical Efficiency

• Using the market leads to higher technical efficiency compared to vertical integration (power of market discipline)

• The difference in technical efficiency of market over vertical integration (∆T) depends on the nature of the assets involved in production

Technical Efficiency

• As the assets become more specialized the market firm’s economies of scale become weaker

• The difference in technical efficiency of market over vertical integration (∆T) declines with greater asset specificity

k= asset specificity

$

∆T

Differential Technical

Efficiency (∆T)

Agency Efficiency

• At high levels of asset specificity, differential agency efficiency of market over vertical integration (∆A) is negative

• When specialized assets are involved, potential for a holdup is high and the result is higher transactions costs

Agency Efficiency

• At low levels of asset specificity, differential agency efficiency of market over vertical integration (∆A) is likely to be positive

• Without the holdup problem, market exchange could be more agency efficient as vertical integration – independent firms face stronger incentives to innovate and

control production costs

k

$

∆A

k*

k>k*: vertical integration is more efficient

k<k*: market is more efficient Differential Agency

Efficiency (∆A)

Technical and Agency Efficiency

Cut off point: k**

∆C= ∆T + ∆A

k>k**→V.I. k<k** → outsource

1. Efficiency Tradeoff

• The combined (market over vertical integration) differential efficiency (∆C) will be negatively related to asset specificity

• At high levels of assets specificity vertical integration is more efficient

• At low levels of assets specificity outsourcing wins

2. Economies of Scale

• As the economies of scale in production become less pronounced vertical integration becomes more attractive – downward shift in ∆T→ ∆C – a wider range in which vertical integration is preferred to

market contracting – If ∆T=0→k**=k (decision is based entirely on agency efficiency)

3. Efficiency Tradeoff and Scale (Q↑)

• When the scale of production increases, the vertically integrated firm enjoys better economies of scale

• With increased scale (Q), the differential technical efficiency decreases for every level of asset specificity

• With an increase in scale (Q), the differential agency efficiency becomes more sensitive to asset specificity

• Differential agency efficiency (market over vertical integration) will increase with scale for low asset specificity

• With high asset specificity, differential agency efficiency decreases with scale

Efficiency Tradeoff and Scale cont. • The combined differential efficiency (∆C) sharply declines for

low asset specificity • The degree of asset specificity at which market is just

competitive with vertical integration declines • Vertical integration is preferred to market exchange over a

larger range of asset specificity

k***<k**

Conclusions From the Efficiency Tradeoff Model

• Inputs in the firm of routine products and services are likely to be… – procured in the market (supplier’s economies of scale)

• When a firm’s product market activities is large in scale, it is likely to… – be vertically integrated

• Presence of relationship-specific assets will tilt the advantage in favor of … – vertical integration

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Real-World Evidence

• GM is more vertically integrated than Ford is, for the same asset specificity (reason) – scale (Q)

• In aerospace, greater design specificity increases the likelihood of … – vertical integration of production

• In the electronics components industry firms rely on own sales force: – when there is greater asset specificity – when they are larger manufacturers – when performance measurement is more difficult

Alternatives to Vertical Integration

Alternatives to Vertical Integration

• Tapered integration (making some and buying the rest)

• Joint ventures and strategic alliances • Long term collaborative relationships • Implicit contracts between firms

Tapered Integration

• A firm may produce part of its input on its own and purchase the rest (Pepsi, Coca-Cola)

• A firm may sell part of its output through in-house sales efforts and sell the rest through independent distributors (Exxon)

Tapered Integration: Advantages

• Additional input/output channels without massive capital investments

• Information about costs and profitability from internal operations can help in negotiating with market firms

• Threat of self manufacture can discipline external channels

• Internal supply capabilities will protect against potential holdups

• Potential expansion of external supply can impose discipline on in-house production

Tapered Integration: Disadvantages

• Possible loss of economies of scale. • Coordination may become more difficult since the

two production units must agree on product specifications and delivery times.

• Managers may be self-serving in continuing with internal production well after it has become inefficient to do so.

Strategic Alliances and Joint Ventures

• Alliances and joint ventures are intermediate solutions, between market exchange and vertical integration

• Alliances involve cooperation, coordination and information sharing for a joint project while the participating firms continue to be independent

• A joint venture is an alliance where a new independent organization is created and jointly owned by the promoting firms

Strategic Alliance

• Rather than rely on contracts, an alliance relies on trust and reciprocity

• Disputes are rarely litigated but resolves through negotiation

What kind of transactions should be organized with Strategic Alliance?

1. Uncertainty surrounding future activities prevents the parties from going into the specifics of those decisions in a contract

2. Transactions are complex and one cannot count on contract law to “fill the gaps”

3. Existence of relationship-specific assets and potential holdup problem

4. Any one party does not have the expertise to organize the transaction internally

5. Market opportunity that induced the transaction is expected to last very long making a long term contract or merger unattractive

6. Regulatory environment necessitates acquiring a local partner for the venture

Collaborative Relationships

• Japanese industrial firms appear to be less vertically integrated compared to their western counterparts

• Japanese firms organize the vertical chain using long term collaborative relationship among firms rather than arm’s length transactions

• Recent trend in the west is to choose vertical disintegration and focus on core competencies

• Any one party does not have the expertise to organize the transaction internally

• Market opportunity that induced the transaction is expected to last very long making a long term contract or merger unattractive

• Regulatory environment necessitates acquiring a local partner for the venture

Collaborative Relationships

• Two major types of collaborative relationships are found in Japan • Subcontractor networks:

• Japanese manufacturers maintain close, informal, long term relationship with their network of subcontractors

• The typical relationship between a manufacturer and a subcontractor involves far more asset specificity in Japan than in the West

• Keiretsu: • Members with strong institutional linkages • Links further strengthened by social affiliation and personal

relationship among executives • Easy coordination and no holdups when vertical chain

activities are performed by keiretsu members

Evidence of Keiretsus

Evidence of Keiretsus

• Recent research indicates that Keiretsus are not what they were thought to be

• Members borrow from their central banks as well as from outside banks

• Members have extensive business dealings outside their Keiretsus

• Profitability of Keiretsus have always been average

Implicit Contracts

• Implicit contracts are unstated understanding between firms in a business relationship

• Longstanding relationship between firms can make them behave cooperatively towards each other without any formal contracts

• The threat of losing future business (and the future stream of profits) is enough to deter opportunistic behavior in any one period

• The desire to protect one’s reputation in the market place can be another mechanism that makes implicit contracts viable