Organizing Vertical Boundaries:

1
Organizing Vertical Boundaries Vertical
Integration and its Alternatives Chapter 4
2
Economics of Vertical Integration
Alternative Ways of Explaining Vertical
Integration
Economizing and Cost Trade-Offs
Grossman-Hart Asset Ownership
Other Motives
3
Technical and Agency Efficiency
Technical (Production) Efficiency implies that a
firm is producing at least possible cost.
Encompasses
Technology Utilization
Scale and Scope Efficiency
Agency Efficiency refers to the extent to which
the exchange of goods and services in the
vertical chain is organized to minimize
coordination, agency and transaction costs
Economizing finding the optimal vertical
organization that minimizes the sum of production
efficiency and agency costs.
4
Vertical Integration, Production and Product
Market Scale
Scale and Scope Economies
Firms gain less from vertical integration the
greater the ability of outside market specialists
to take advantage of economies of scale and scope
Product Market Scale and Growth
Firms gain more from vertical integration the
larger is the scale of its product market
activities
Asset Specificity
Firms gain more from vertical integration when
production of inputs involves investments in
relationship specific assets.
5
Vertical Integration and Asset Ownership
Possible Organizational Arrangements
Nonintegration the firms remain independent,
each controlling its own assets and making its
own operating decisions
Forward Integration Firm 1 owns the assets of
Firm 2 and Firm 1 has control over both sets of
operating decisions
Backward Integration Firm 2 owns the assets of
Firm 1 and Firm 2 has control over both sets of
operating decisions
Asset Ownership should be given to the firm whose
investments have the strongest impact on total
profits of the venture
6
Process Issues in Vertical Mergers
Assessing the efficiency effects of a merger in
the vertical chain must take into account the
governance arrangements between the acquiring and
acquired firm
Decision-making rights should be granted to those
managers who have the greatest impact on the
performance and profitability of the firm
creates path dependence
corporate culture
7
Alternatives to Vertical Integration
Tapered Integration is a mixture of vertical
integration and market exchange
Benefits
expands input or output channels without
substantial capital outlays
Firm can use information about internal cost and
profitability of internal channels to negotiate
contracts with independent channels
Firm can develop internal supply capabilities to
protect against holdup by independent suppliers
Costs
Shared production arrangements may not allow
attainment of existing scale economies
Coordination and monitoring problems can be high
8
Alternatives to Vertical Integration
Strategic Alliances and Joint Ventures
In a strategic alliance two or more firms agree
to collaborate on one or more projects, or share
information and productive resources
Horizontal Alliances
Vertical Alliances
Joint Venture two or more firms create and
jointly own a new independent organization
9
A strategic alliance or joint venture is
desirable when
Development, production or marketing of a product
requires expertise in a number of functions areas
It is excessively costly for any one firm to
develop the necessary expertise itself
Successful development, production or marketing
requires close coordination among different areas
of expertise
Joint Ventures are appealing because they can
combine the scale and scope advantages achieved
by independent firms and the coordination of
design attributes associated with vertically
integrated firms
10
Alternatives to Vertical Integration
Implicit Contracts and Long-term Relationships
11
Tradeoff Between Agency and Technical Efficiency