More on Vertical Relationships

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More on Vertical Relationships
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The Make or Buy Decision

• Firms should internalize those activities that
  can be conducted within the firm more profitably
  than they can be purchased in the market and
  should purchase the others.
• Three basic drivers of vertical integration
• technological economies,
• transactional economies, and
• market imperfections.

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Technological economies

• Economies of scope or scale Side-by-side
  production, common inputs, level of production.
• Firms that can achieve the minimum efficient
  scale may want to make their own inputs so as to
  save on other costs such as transportation costs.
• Firms that do not use a sufficient quantity to
  achieve efficient scale of operations should buy
  the input from a large supplier that is producing
  at the most efficient scale.

4
Transactional economies

• Market exchanges involve costs transportation,
  contracts, negotiations, etc.
• Also less direct costs in cases of asset
  specificity and incomplete contracts.
• If one party must make sunk investments during a
  transaction because assets are specialized, then
  there is the potential for opportunistic behavior
  for both parties.
• The lack of a complete contract (either because
  such contracts are too costly or are not
  enforceable) implies that one of the parties
  might be able to hold up the other and extract
  quasi-rents.
• Because VI implies control, opportunistic
  behavior should not occur under vertical
  integration.

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Market Imperfections

• Vertical integration can serve to raise entry
  barriers and thus create an imperfectly
  competitive market.
• Vertical integration can also result from
  uncertainty or private information.
• Firms with relatively constant input requirements
  may integrate backward to avoid paying high
  prices for inputs that are driven by erratic
  demands of other buyers.
• By acquiring information about the costs of a
  successive production process, a vertically
  integrated firm is able to make more efficient
  quantity decisions.

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Why Buy?

• Internal organization and management is not
  costless.
• Amount and cost of monitoring required to run a
  firm efficiently increase as the size of the firm
  increases.
• Firm must balance any benefits it receives from
  VI against the increasing costs of control
  associated with internal transactions.
• Also, as firms vertically integrate away from
  their core businesses, they may not have
  sufficient knowledge or experience to manage
  these additional activities effectively.

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Market Foreclosure

• Firms may vertically integrate (or impose
  vertical restraints) to facilitate market
  foreclosure, i.e. to deny competitors the
  products from an upstream industry or make prices
  so high as to put the competitors at a
  disadvantage.
• Assume that there are both integrated and
  non-integrated firms in a market.
• Integrated firm gets inputs at cost, non
  integrated firm pays a markup over the cost.

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Market Foreclosure, cont

• Assume NU firms in the upstream market and ND
  firms in the downstream market.
• Demand for the downstream product is P a-bQ
• ?D (PD - PU - cD) if the firm is non integrated
• ?D (PD - cD - cU) if the firm is integrated
• At most, the upstream firm can charge PD - cD so
  it will net PD - cD - cU. (At a higher price,
  demand would be zero since costs for the
  downstream firm would exceed price.)
• By "selling" this unit to itself -- total output
  of the market does not change and it gets PD - cD
  - cU