Vertical integration

1
Vertical integration

• When does outsourcing/ownership matter?

2
What is vertical integration?

• Vertical (or horizontal) integration means that
  the assets that were previously held by two firms
  are combined into a single firm.
• The result is either joint ownership or the sale
  of one firms assets to the other.

3
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 anticipating
  impact on demand

4
Vertical Integration

• Suppose upstream and downstream firms are
  commonly owned
• Best internal transfer price is based on upstream
  marginal cost, c.
• Market price set so that MR c.
• Maximises joint profits

5
Impact on Profits
6
Double Marginalisation

• With outsourcing
• Both firms charge a mark-up
• Higher prices, low overall profits, lower
  consumer welfare (not very competitive if there
  is another vertical chain)
• Solved by
• Vertical integration
• Two-part tariffs
• More downstream or upstream competition

7
Can vertical integration matter?

• The Coase Theorem tells us that asset ownership
  does not matter for efficiency.
• Assumes complete contracting
• When contracts are incomplete there exist
  residual rights of control (unspecified actions).
  According to Grossman 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 productive
  activities.

8
GM-Fisher Body

• 1920s General Motors purchased car bodies from
  independent firm (Fisher Body)
• Technology change wooden to metal
• GM built a new assembly plant that required
  reliable supply
• wanted Fisher Body to build a new car body plant
  next to it
• no need for shipping docks etc.

9
Fisher Refused

• Fisher Body refused to make this investment.
• Feared that a plant so closely tailored to GMs
  needs would be vulnerable to GMs demands
  (hold-up)
• Eventually resolved this issue by vertical
  integration -- could not find a contractual
  solution

10
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 to appropriate these at expense of
  managers.
• Harder to keep those costs down.

11
Bottling Pepsi

• PepsiCo has two types of bottlers
• Independent owns assets of bottling operation
  and exclusive rights to franchise territory. Can
  determine how these are used - when to restock
  stores etc.
• Company owned decisions can be made higher up
  Pepsi can choose to delegate local marketing to
  its subsiduary

12
Pepsis Control

• Pepsi cannot control how an independent bottler
  operates 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.

13
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 be non-contractible
• Also assume that care is a skill that is
  developed (through habits etc.). Therefore, it
  becomes embedded in the truckers human capital.

14
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 gt 100 Marginal Cost
• Efficient to take care
• What happens under different ownership structures
  for the asset?

15
Non-contractible Investment

• Suppose bargaining took place after effort choice
  is made
• 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
  is less than the T if they do not own the asset.

16
Will trucker take care?
Ex Post Added Values How to Share 200
17
Incentives and Ownership

• Trucker can be easily replaced if does not take
  care. However, under BI and 3rd party ownership
  (vertical separation), does not expect to earn
  enough to cover costs of 100.
• Will take care under FI needs to have control
  rights (i.e., right to exclude use of asset) in
  order to gain sufficient 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
  taking care gives them 25.
• General principle give control rights to agents
  making important investments.

18
Efficient Integration Level

• As they encourage the trucker to take care,
  forward integration is the only efficient
  organisational form
• Do we expect asset ownership to track efficiency?

19
Shipper Interests

• Shipper might choose to have a back haul. A back
  haul adds value of 100 (independent of level of
  care).
• Suppose that trucker if they own the truck
  can find alternative customers for the back haul.
  If expend cost of 10 will find alternative
  customer adding value of 50.

20
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 surplus
  from 150 to 175 therefore, worth the 10
  expense.
• If search very costly, BI may become efficient
  again.

21
Optimal Firm Boundaries

• Ownership provides maximal incentives to take
  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)

22
What Happens in Trucking?

• Suppose that you could put on-board computers on
  truckers to monitor drivers.
• Theory easier to monitor drivers care and
  reflect it in explicit performance payments or
  fines therefore, less need for trucker
  ownership.
• Baker Hubbard (2000) use of OBCs has increased
  non-trucker ownership especially on routes that
  may be more subject to trucker rent seeking.

23
Shipper vs. Carrier ownership

• What determines whether shippers use internal
  (captive) fleets or for-hire carriers for a haul?
• Determines who owns control rights associated
  with dispatch (truck scheduling)
• Shippers use internal fleets when want high
  service levels from truck drivers
• Truck utilisation higher in for-hire fleets
  ability to line up a sequence of hauls for a
  truck tight coordination (requires dispatcher
  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

24
Case Insurance Industry

• Insurance industries
• In-house sales force whole life
• Independent brokers fire and casualty
• Choice determines ownership of client list

25
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 increase
  premiums that reduce renewal commission

26
Applying Grossman Hart

• Choice between independent and in-house agents
  should turn on relative importance of investments
  in developing 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 is important -- independent

27
Dynamic Issues

• How does outsourcing and integration performance
  change over time?

28
T5 at Heathrow

• Project management handled internally
• Contractors on cost-plus contracts (not fixed
  price as is usually the case)
• British Airports Authority wanted to keep options
  open to change design specifications throughout
  the life of the project
• Happy to engage in on-going managerial attention

29
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 (also anticipated in tender)
• Cost plus contracts
• Costs are passed through
• Low powered incentives
• No difficult renegotiations easier to change
  designs during project
• For complex projects that require lots of
  coordination, may be better to use cost plus
  contracts

30
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 supply after 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 there are much greater
  opportunities for improvements over time

31
Performance Over time
32
Empirical Findings
Performance(Consumer Reports)
Internal Sourcing
Outsourcing
Model Year
33
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

34
Principles of Efficient Ownership

• 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

35
Ownership Outcomes
36
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

37
Ownership Outcomes
38
Complementary Assets

• Now suppose there are other customers who can use
  the yacht
• But tycoon can choose a non-contractible action
  (e.g., plan entertainment schedule for the year).
  Gives additional value of 240.
• Yacht can be split in two galley and hull

39
Divided Ownership

• Is it ever optimal for chef to own galley and
  skipper 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)

40
Principles

• Never give ownership to dispensable individuals
• Give ownership to indispensable agents (even
  though may not make an investment)
• Vest ownership of complementary assets with a
  single individual

41
Qualification

• Does asset ownership really improve incentives
  for specific 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 by ownership

42
Summary

• Value of ownership
• Increased bargaining position (added value)
• Incentives to take non-contractible actions
• Ownership improves this by allowing agent to
  capture a greater share of the rewards
• But diminishes the incentives of non-owners
• Who should own an asset?
• Agents taking non-contractible actions
• Important agents