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ECP 6701

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Title: ECP 6701


1
ECP 6701 Competitive Strategies in Expanding
Markets
Vertical Boundaries of the Firm
2
Readings
  • BDSS Chapter3

3
Vertical Chain
  • 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

4
Vertical Boundaries of the Firm
  • Which steps of the vertical chain are to be
    performed inside the firm?
  • Which steps of the vertical chain to be
    out-sourced?
  • Choice between the invisible hand of the market
    and the visible hand of the organization (Make
    or Buy)

5
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)

6
Support Services
  • Accounting
  • Finance
  • Legal Support
  • Marketing
  • Planning
  • Human Resource Management

7
Defining Boundaries
  • Firms need to define their vertical boundaries
  • Considerations
  • Economies of scale achieved by market firms
  • Value of market discipline
  • Ease of coordination of production flows in-house
  • Transactions costs when dealing with market firms

8
Reasons to Buy rather than Make
  • Market firms (outside specialists) may have
    patents/proprietary information that makes low
    cost production possible
  • Market firms can achieve economies of scale that
    in-house units cannot
  • Market firms are subject to market discipline,
    whereas in-house units may be able to hide their
    inefficiencies behind overall corporate success
    (Agency and influence costs)

9
Economies of Scale
10
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

11
Economies of Scale
  • An automobile manufacturer would rather buy
    anti-lock brakes from an independent supplier
    than from a competitor
  • Minimum efficient scale may be feasible for the
    independent supplier but not for an automobile
    manufacturer

12
Economies of Scale
  • Will the outside supplier charge c (its average
    cost) or c (the average cost for the
    manufacturer for in-house production)?
  • The answer depends on the degree of competition
    faced by the supplier

13
Agency and Influence Costs
  • The incentives to be efficient and innovative are
    weaker when a task is performed in-house
  • 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

14
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

15
Reasons to Make
  • Costs imposed by poor coordination
  • Reluctance of partners to develop and share
    valuable private information
  • Transactions cost that can be avoided by
    performing the task in-house
  • Each problem can be traced to difficulties in
    contracting

16
Role of Contracts
  • Firms often use contracts when certain tasks are
    performed outside the firm
  • Contracts list
  • the set of tasks that need to be performed
  • the remedies if one party fails to fulfill its
    obligation

17
Contracts
  • Contracts protect each party to a transaction
    from opportunistic behavior of other(s)
  • Contracts ability to provide this protection
    depends on
  • the completeness of contracts
  • the body of contract law

18
Complete Contract
  • A complete contract stipulates what each party
    should do for every possible contingency
  • No party can exploit others weaknesses
  • To create a compete contract one should be able
    to contemplate all possible contingencies
  • One should be able to map from each possible
    contingency to a set of actions
  • One should be able to define and measure
    performances
  • One should be able to enforce the contract

19
Complete Contract (Continued)
  • To enforce a contract, an outside party (judge,
    arbitrator) should be able to
  • observe the contingency
  • observe the actions by the parties
  • impose the stated penalties for non-performance
  • Real life contracts are usually incomplete
    contracts

20
Incomplete Contracts
  • Incomplete contracts
  • Involve some ambiguities
  • Need not anticipate all possible contingencies
  • Do not spell out rights and responsibilities of
    parties completely

21
Factors that Prevent Complete Contracting
  • Bounded rationality
  • Difficulties in specifying/measuring performance
  • Asymmetric information

22
Bounded Rationality
  • Individuals have limited capacity to
  • Process information
  • Deal with complexity
  • Pursue rational aims
  • Individuals cannot foresee all possible
    contingencies

23
Specifying/Measuring Performance
  • Terms like normal wear and tear may have
    different interpretations
  • Performance cannot always be measured
    unambiguously

24
Asymmetric Information
  • Parties to the contract may not have equal access
    to contract-relevant information
  • One party can misrepresent information with
    impurity

25
Contract Law
  • Contract law facilitates transactions with
    incomplete contracts
  • Parties need not specify provisions that are
    common to a wide class of transactions

26
Limitations of Contract Law
  • Doctrines of contract law are in broad language
    that could be interpreted in different ways
  • Litigation can be a costly way to deal with
    breach of contract
  • Litigation can be time consuming
  • Litigation weakens the business relationship

27
Coordination of Production Flows
  • For successful coordination one party needs to
    make decisions that depend on the decision made
    by others
  • A good fit should be accomplished in several
    dimensions. Some examples are
  • Timing
  • Size
  • Color
  • Sequence

28
Coordination Problems
  • Without good coordination, bottlenecks arise in
    the vertical chain
  • Coordination is especially important when design
    attributes are present
  • To ensure coordination, firms rely on contracts
    that specify delivery dates, design tolerances
    and other performance targets

29
Leakage of Private Information and Outsourcing
  • Firms would not want to compromise the source of
    their competitive advantage
  • Well- defined patents can help but may not
    provide full protection
  • Contracts with non compete clauses can be used to
    protect against leakage of information
  • In practice non-compete clauses can be hard to
    enforce

30
Transactions Costs
  • If the market mechanism improves efficiency, why
    do so many of the activities take place outside
    the price system? (Coase)
  • Costs of using the market that are saved by
    centralized direction transactions costs

31
Transactions Costs
  • Outsourcing 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

32
Transactions Costs
  • Sources of transactions costs
  • Investments that need to be made in relationship
    specific assets
  • Possible opportunistic behavior after the
    investment is made (hold up problem)
  • Quasi-rents (magnitude of hold up problems)

33
Relationship-Specific Assets
  • Relation-specific assets are essential for a
    given transaction
  • These assets cannot be redeployed for another
    transaction costlessly
  • Once the asset is in place, the other party to
    the contract cannot be replaced costlessly,
    because the parties are locked into the
    relationship to some degree

34
Relationship-Specific Assets Examples
  • An aluminum refiner invests in a refinery
    designed to process a particular grade of bauxite
    ore
  • The French government invests in transportation
    infrastructure for Euro-Disney

35
Forms of Asset Specificity
  • Relation-specific assets may exhibit different
    forms of specificity
  • Site specificity
  • Physical asset specificity
  • Dedicated assets
  • Human asset specificity

36
Rent and Quasi-rent
  • 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 form an alternate transaction

37
Rent and Quasi-rent
  • 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 p1
  • If A were to renege on the agreement and B is
    forced to sell its output in the open market, the
    economic profit will be p2

38
Rent and Quasi-rent
  • Rent is the minimum economic profit needed to
    induce A to enter into this agreement with B (p1)
  • Quasi-rent is the economic profit in excess on
    the minimum needed to retain A in the selling
    relationship with B (p1- p2)

39
The Holdup Problem
  • Whenever p1 gt p2, 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-specifi
    c assets, quasi-rent may exist and lead to the
    holdup problem

40
Effect on Transactions Costs
  • The holdup problem raises the cost of transacting
    exchanges
  • Contract negotiations become more difficult
  • Investments may have to be made to improve the
    ex-post bargaining position
  • Potential holdup can cause distrust
  • There could be underinvestment in relation
    specific assets

41
Holdup and Contract Negotiations
  • When there is potential for holdup, contract
    negotiations become tedious as each party
    attempts to build in protections for itself
  • Temptations on the part of either party to holdup
    can lead to frequent renegotiations
  • There could be costly disruptions in the exchange

42
Holdup and Costly Safeguards
  • Potential for holdup may lead parties to invest
    in wasteful protective measures
  • Manufacturer may acquire standby production
    facility for an input that is to be obtained from
    a market firm
  • Floating power plants are used in place of
    traditional power plants to avoid site specific
    investments

43
Holdup and Distrust
  • Potential holdups cause distrust between parties
    and raise the cost of transactions
  • Distrust can make contracting more costly since
    contracts will have to be more detailed
  • Distrust affects the flow of information needed
    to achieve process efficiencies

44
Holdup and Underinvestment
  • When there is a holdup, the investment made in
    relationship-specific assets loses value
  • Anticipating holdups, firms will make otherwise
    sub-optimal level of investments and suffer
    higher production costs

45
Asset Specificity and Transactions Costs
  • Relation-specific assets support a particular
    transaction
  • Redeploying to other uses is costly
  • Quasi rents become available to one party and
    there is incentive for a holdup
  • Potential for holdups lead to
  • Underinvestment in these assets
  • Investment in safeguards
  • Reduced trust

46
Summary
  • Production activities flow from upstream
    suppliers to downstream manufacturers,
    distributors, and retailers (vertical chain).
  • The make or buy problem determines the vertical
    boundaries of a firm.
  • The solution to this problem depends on option
    leads to most efficient production.
  • This requires an assessment of the cost and
    benefits of using the market.

47
Summary
  • Market firms can exploit economies of scale to
    produce a component cheaper.
  • Market firms are subject to competition which
    encourages efficiency and innovation.
  • Vertically integrated firms might face agency and
    influence costs.

48
Summary
  • Use of market transactions entails coordination
    problems (especially for production of inputs
    with complex design requirements).
  • Use of market transactions may lead to lose
    control of valuable private information.
  • Use of market transaction might entail
    contracting costs.
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