Title: ECP 6701
1ECP 6701 Competitive Strategies in Expanding
Markets
Vertical Boundaries of the Firm
2Readings
3Vertical 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
4Vertical 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)
5Make 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)
6Support Services
- Accounting
- Finance
- Legal Support
- Marketing
- Planning
- Human Resource Management
7Defining 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
8Reasons 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)
9Economies of Scale
10Economies 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
11Economies 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
12Economies 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
13Agency 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
14Influence 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
15Reasons 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
16Role 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
17Contracts
- 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
18Complete 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
19Complete 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
20Incomplete Contracts
- Incomplete contracts
- Involve some ambiguities
- Need not anticipate all possible contingencies
- Do not spell out rights and responsibilities of
parties completely
21Factors that Prevent Complete Contracting
- Bounded rationality
- Difficulties in specifying/measuring performance
- Asymmetric information
22Bounded Rationality
- Individuals have limited capacity to
- Process information
- Deal with complexity
- Pursue rational aims
- Individuals cannot foresee all possible
contingencies
23Specifying/Measuring Performance
- Terms like normal wear and tear may have
different interpretations - Performance cannot always be measured
unambiguously
24Asymmetric Information
- Parties to the contract may not have equal access
to contract-relevant information - One party can misrepresent information with
impurity
25Contract Law
- Contract law facilitates transactions with
incomplete contracts - Parties need not specify provisions that are
common to a wide class of transactions
26Limitations 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
27Coordination 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
28Coordination 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
29Leakage 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
30Transactions 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
31Transactions 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
32Transactions 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)
33Relationship-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
34Relationship-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
35Forms of Asset Specificity
- Relation-specific assets may exhibit different
forms of specificity - Site specificity
- Physical asset specificity
- Dedicated assets
- Human asset specificity
36Rent 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
37Rent 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
38Rent 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)
39The 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
40Effect 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
41Holdup 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
42Holdup 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
43Holdup 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
44Holdup 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
45Asset 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
46Summary
- 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.
47Summary
- 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.
48Summary
- 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.