economics of strategy - kangwoncc.kangwon.ac.kr/~kimoon/gmi/besanko-5/ch05.pdf · economics of...
TRANSCRIPT
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Economics of Strategy Fifth Edition
Slides by: Richard Ponarul, California State University, Chico
Copyright 2010 John Wiley Sons, Inc.
Chapter 5
The Vertical Boundaries of the Firm
Besanko, Dranove, Shanley and Schaefer
The Vertical Chain
The vertical chain
begins with the acquisition of raw materials and
ends with the sale of finished goods/services.
Organizing the vertical chain is an important part of business strategy
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The Vertical Chain
Vertically integrated firms (Scott Paper) perform all the tasks in the vertical chain in-house.
Vertically disintegrated firms (Nike) outsource most of the vertical chain tasks.
Vertical Boundaries of the Firm
Vertical boundaries of the firm demarcate which tasks in the vertical chain are to be performed inside the firm and which to be out-sourced.
The choice is between the market and the organization is a make or buy decision.
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Make versus Buy
There is a continuum of possibilities between the two extremes
Arms length transactions
Long term contracts
Strategic alliances and joint ventures
Parent/subsidiary relationship
Activity performed internally
Upstream, Downstream
Early steps in the production process are upstream (Timber for furniture)
Later steps are downstream (finished goods in showrooms)
Support services are provided all along the chain
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Make-or-Buy Continuum
Vertical Chain of Production
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Support Services
Accounting
Finance
Legal Support
Marketing
Planning
Human Resource Management
Defining Boundaries
Firms need to define their vertical boundaries.
Outside specialists who can perform vertical chain tasks are market firms.
Market firms are often recognized leaders in their field (Example: UPS).
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Market Firms
Benefits of using market firms Economies of scale achieved by market firms
Value of market discipline
Costs Problems in coordination of production flows
Possible leak of private information
Transactions costs
Some Make-or-Buy Fallacies
Firm should make rather than buy assets that provide competitive advantages
Outsourcing an activity eliminates the cost of that activity
Making instead of buying captures the profit margin of the market firms
Vertical integration insures against the risk of high input prices
Making ties up the distribution channel and denies access to the rivals
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Make-or-Buy & Competitive Advantage
A firm may believe that a particular asset is a source of competitive advantage
But if the asset is easily available in the market the belief regarding competitive advantage will have to be reevaluated
Outsourcing and Cost
It should not matter if the costs of performing an activity are incurred by the firm (Make) or by the supplier (Buy)
The relevant consideration is whether it is more efficient to make or to buy
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Vertical Integration and Profits
The supplier’s profit margin may not represent any economic profit, and profit margin should “pay” for the capital investment and the risk borne
If the supplier is earning economic profit, is there a reason for its persistence?
Market competition should eventually erode away any economic profit
Vertical Integration & Input Price Risk
Instead of vertical integration, long term contracts can be used to reduce input price risk
Forward or futures contracts can also be used to hedge input price risk
Alternately the capital tied up in vertical integration could be used as a contingency fund to deal with price fluctuations.
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Foreclosure of Distribution Channels
Acquiring a downstream monopoly supplier may seem to be a way to tie up channels and increase profits
Three possible limitations
Possible violation of anti trust laws
Price paid for the downstream firm may reflect the full value of the monopoly power
Competitors may be able to open new distribution channels
Foreclosure of Distribution Channels
Foreclosure can succeed if:
Upstream monopolist is unable to commit to higher prices (discounting to more price sensitive buyers)
Upstream firm is creating a network by acquiring several downstream firms
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Reasons to Buy
Market firms may have patents or proprietary information that makes low cost production possible
Market firms can achieve economies of scale that in-house units cannot
Market firms are likely to exploit learning economies
Economies of Scale
Production Costs and the Make-or-Buy Decision
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Economies of Scale
A given manufacturer of automobiles needs A’ units
An outside supplier may reach the minimum efficient scale (A*) by supplying to different automobile manufacturers
The cost is lowered by using the outside supplier
Economies of Scale
Minimum efficient scale may be feasible for the independent supplier but not for an automobile manufacturer.
Automobile manufacturers would rather buy anti-lock brakes from an independent supplier than from a competitor.
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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
Agency Costs
Agency costs are due to slacking by employees and the administrative effort to deter slacking.
When there are joint costs measuring and rewarding individual unit’s performance is difficult.
It is difficult to internally replicate the incentives faced by market firms
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Agency Costs
It can be difficult to evaluate the efficiency when a task is performed by a “cost center” within an organization.
Inherent advantages enjoyed by the firm in the market allows its managers to live with the agency costs
Influence Costs
Performing a task in-house will lead to influence costs.
Internal Capital Markets allocates scarce capital within the firm
Allocations can be favorably affected by influence activities
Resources consumed by influence activities represent influence costs.
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Influence Costs
In-house suppliers can use their influence with headquarters to shield against pressures to become more competitive.
Large vertically integrated firms are more prone to influence cost problems than small independent firms.
Reasons to Make
Costs imposed by poor coordination
Reluctance of partners to develop and share private information
Transactions cost that can be avoided by performing the task in-house
Each of the three problems can be traced to difficulties in contracting
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Role of Contracts
Firms often use contracts when certain tasks are performed outside the firm.
The contracts list
the set of tasks that need to be performed and
the remedies if one party fails to fulfill its obligation.
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
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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
Complete Contract (Cont.)
A complete contract maps each possible contingency to a set of stipulated actions
One should be able to define and measure performance
The contract must be enforceable
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Complete Contract (Cont.)
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
Incomplete Contracts
Incomplete contracts involve some ambiguities
They do not anticipate all possible contingencies
They do not spell out rights and responsibilities of parties completely
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Factors that Prevent Complete Contracting
Bounded rationality
Difficulties in specifying/measuring performance
Asymmetric information
Bounded Rationality
Individuals have limited capacity to
process information
deal with complexity
pursue rational aims
Individuals cannot foresee all possible contingencies
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Specifying/Measuring Performance
What constitutes fulfillment of a contract may have some residual vagueness.
Terms like “normal wear and tear” may have different interpretations.
Performance cannot always be measured unambiguously.
Asymmetric Information
Parties to the contract may not have equal access to contract-relevant information.
The knowledgeable party can misrepresent information with impunity.
Contracting on items that rely on this information is difficult.
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Contract Law
Contract law facilitates transactions when contracts are incomplete.
Parties need not specify provisions that are common to a wide class of transactions.
In the U. S. contract law is embodied in common law and the Uniform Commercial Code.
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
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Coordination of Production Flows
Firms make decisions that depend in part on the decisions made by other firms along the vertical chain.
A good fit will have to be accomplished in all dimensions of production. (Examples: Timing, Size, Color and Sequence)
Coordination Problems
Without good coordination, bottlenecks arise in the vertical chain
To ensure coordination, firms rely on contracts
Firms also use merchant coordinators – independent specialists who work with firms along the vertical chain
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Coordination Problems
Coordination is especially important when design attributes are present
Design attributes are attributes that need to relate to each other in a precise fashion. Some examples are:
Fit of auto sunroof glass to aperture
Timely delivery of a critical component
Small errors can be extremely costly.
Design Attributes
If coordination is critical, administration control may replace the market mechanism
Design attributes may be moved in-house
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Leakage of Private Information
Firms do not want to compromise the source of their competitive advantage .
Private information on product design or production know-how may be compromised when outside firms are used in the vertical chain.
Leakage of Private Information
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
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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
Outsourcing entails costs of negotiating, writing and enforcing contracts
Transactions Costs
Costs incurred due to opportunistic behavior of parties to the contract and efforts to prevent such behavior are transaction costs as well.
Transactions costs explain why economic activities occur outside the price system (inside the firm).
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Transactions Costs
Sources of transactions costs
Investments that need to be made in relationship specific assets
Possible opportunistic behavior after the investment is made (holdup problem)
Quasi-rents (magnitude of the holdup problems)
Relationship-Specific Assets
Relation-specific assets are assets essential for a given transaction
These assets cannot be redeployed for another transaction without cost
Once the asset is in place, the other party to the contract cannot be replaced without cost, because the parties are locked into the relationship to some degree
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Forms of Asset Specificity
Relation-specific assets may exhibit different forms of specificity
Site specificity
Physical asset specificity
Dedicated assets
Human asset specificity
Site Specificity
Assets may have to be located in close proximity to economize on transportation costs and inventory costs and to improve process efficiency
Cement factories are usually located near lime stone deposits
Can-producing plants are located near can-filling plants
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Physical Asset Specificity
Physical assets may have to be designed specifically for the particular transaction
Molds for glass container production custom made for a particular user
A refinery designed to process a particular grade of bauxite ore
Dedicated Assets
Some investments are made to satisfy a single buyer, without whose business the investment will not be profitable.
Ports investing in assets to meet the special needs of some customers
A defense contractor’s investment in manufacturing facility for making certain advanced weapon systems
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Human Asset Specificity
Some of the employees of the firms engaged in the transaction may have to acquire relationship-specific skills, know-how and information Clerical workers acquire the skills to use a
particular enterprise resource planning software
Salespersons posses detailed knowledge of customer firm’s internal organization
Fundamental Transformation
Prior to the investment in relationship specific assets there are many trading partners.
Once the investment is made the situation becomes a bargaining situation with a small number partners
Relationship specific assets cause a fundamental transformation in the relationship
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Rents and Quasi-Rents
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 from an alternate transaction
Rents and Quasi-Rents
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 π1
If B were to renege on the agreement and A is forced to sell its output in the open market, the economic profit will be π2
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Rents and Quasi-Rents
Rent is the minimum economic profit needed to induce A to enter into this agreement with B (π1)
Quasi-rent is the economic profit in excess on the minimum needed to retain A in the selling relationship with B (π1- π2)
The Holdup Problem
Whenever π1 > π2, 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-specific assets, quasi-rent may exist and lead to the holdup problem
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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 relationship specific assets
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
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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
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
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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
The Holdup Problem: Summary
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
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Double Marginalization
Vertical integration helps if both the upstream firm and the downstream firm have market power
Upstream firm sets its price above marginal cost
Vertical integration increases output, lowers the final price and increases the profits
The Make-or-Buy Decision Tree