The Vertical Boundaries of the FirmThe Vertical Boundaries of the Firm

Upstream, DownstreamUpstream, Downstream Defining BoundariesDefining Boundaries Benefits and Constraints of Using the MarketBenefits and Constraints of Using the Market Information AsymmetryInformation Asymmetry The Nature of the FirmThe Nature of the Firm Organizing Vertical Boundaries of the FirmOrganizing Vertical Boundaries of the Firm Technical Efficiency and Agency EfficiencyTechnical Efficiency and Agency Efficiency Asset Ownership and Vertical Boundaries of the FirmAsset Ownership and Vertical Boundaries of the Firm

Upstream, DownstreamUpstream, Downstream

Any firm’s activity is part of a Any firm’s activity is part of a vertical chainvertical chain in a particular industry or in a particular industry or economic sector.economic sector.

Goods “flow” in any economy within different vertical chains, where raw Goods “flow” in any economy within different vertical chains, where raw materials at manufacturing level become finished goods distributed and retailed materials at manufacturing level become finished goods distributed and retailed to final customers.to final customers.

Vertical chainsVertical chains are processes where added value is being generated at each are processes where added value is being generated at each step, i.e. manufacturing, distribution and retailing. Economists argue that step, i.e. manufacturing, distribution and retailing. Economists argue that “early steps are “early steps are upstreamupstream in the production process, and later steps are in the production process, and later steps are downstreamdownstream (…).” (…).”[i] [i] Besanko, David; Dranove, David; Shanley, Mark. “Economics of Strategy”, p. 71, Besanko, David; Dranove, David; Shanley, Mark. “Economics of Strategy”, p. 71, New York: John Wiley & Sons, Inc. 1986New York: John Wiley & Sons, Inc. 1986

Any firm has Any firm has four decision choicesfour decision choices, as follows:, as follows:             Going upstream along the vertical chain,Going upstream along the vertical chain,             Performing downstream along the vertical chain,Performing downstream along the vertical chain,             Having “in-house” professional supporting activities,Having “in-house” professional supporting activities,       Buying professional supporting activities from aBuying professional supporting activities from a market firmmarket firm..

The four decision choices form the The four decision choices form the “make-or-buy” decision “make-or-buy” decision framework. framework.

A good manager should make the right decision according to A good manager should make the right decision according to firm’s unique capabilities. firm’s unique capabilities.

Going upstream or downstream is a strategic choice that any Going upstream or downstream is a strategic choice that any organizational leader should make based on firm’s unique capabilities.organizational leader should make based on firm’s unique capabilities.

Defining BoundariesDefining Boundaries

A firm must decide whether it needs to use the market or performing A firm must decide whether it needs to use the market or performing the activity in-house. Firm’s boundaries are determined by “the the activity in-house. Firm’s boundaries are determined by “the capabilities of the firm relative to the capabilities of the market.”capabilities of the firm relative to the capabilities of the market.”[i] In In the long run, if the costs of using firm’s capabilities exceed the the long run, if the costs of using firm’s capabilities exceed the benefits, the firm will have to find alternative ways by buying benefits, the firm will have to find alternative ways by buying specialized supporting activities from a specialized supporting activities from a market firm.market firm.

In the same way, on the long run, if the costs of using market’s In the same way, on the long run, if the costs of using market’s capabilities are greater than the benefits, the firm will have to develop capabilities are greater than the benefits, the firm will have to develop its in-house capabilities.its in-house capabilities.

The organizational abilities of maximizing potential benefits of using The organizational abilities of maximizing potential benefits of using either in-house capabilities or professional supporting activities from either in-house capabilities or professional supporting activities from market firms are factors that shape firm’s boundaries.market firms are factors that shape firm’s boundaries.

[i] Langlois, R. N., & Robertson, P. L. 1995. “Firms, Markets and Langlois, R. N., & Robertson, P. L. 1995. “Firms, Markets and Economic Change: A Dynamic Theory of Business Institutions”, Economic Change: A Dynamic Theory of Business Institutions”, London: Routledge, p. 33London: Routledge, p. 33

Benefits and Constraints of Using the MarketBenefits and Constraints of Using the Market Benefits of Using the MarketBenefits of Using the Market

Organizations use Organizations use market firmsmarket firms when the potential benefits of when the potential benefits of “employing” market’s capabilities are greater than its incurring costs. “employing” market’s capabilities are greater than its incurring costs. Moreover, firms use the market if they “can take advantage of the hard-Moreover, firms use the market if they “can take advantage of the hard-edged incentives that only the market can offer.”edged incentives that only the market can offer.”[i][i] Besanko et al. Op. cit., p. 77 Besanko et al. Op. cit., p. 77

Here are some potential advantages of using the market:Here are some potential advantages of using the market:

- - “Market firms can achieve economies of scale.”“Market firms can achieve economies of scale.”[i] [i] Ibid. p. 77 Ibid. p. 77

- - “Market Firms are Subject to the Discipline of the Market”“Market Firms are Subject to the Discipline of the Market”[i] [i] Ibid. p. 84 Ibid. p. 84

Organizational leaders should be aware of market’s capabilities that Organizational leaders should be aware of market’s capabilities that might be used for the business. The leaders should, also, be aware of the might be used for the business. The leaders should, also, be aware of the additional costs that might occur when the effort paid for using those additional costs that might occur when the effort paid for using those market capabilities become greater than the cost paid for using the market capabilities become greater than the cost paid for using the organizational capabilities. organizational capabilities.

Information Asymmetry Information Asymmetry The information is asymmetric when one or more parties in a contract or The information is asymmetric when one or more parties in a contract or

organizational context have more or better information than the other one(s). organizational context have more or better information than the other one(s). The CEO of a complex organizational structure may face the risk of not The CEO of a complex organizational structure may face the risk of not

having access to the correct information or the information provided is not having access to the correct information or the information provided is not reflecting the real “picture”. reflecting the real “picture”.

The decision making process is, sometimes, a multistage process with the The decision making process is, sometimes, a multistage process with the information being, firstly, received by the division-level management and, information being, firstly, received by the division-level management and, then, communicated to upper managerial level. The information might be then, communicated to upper managerial level. The information might be distorted when there is a multistage decision making process. distorted when there is a multistage decision making process.

There are voices arguing that it might be a sort of distorted competition, i.e. There are voices arguing that it might be a sort of distorted competition, i.e. competition between more than one organizational divisions for influencing competition between more than one organizational divisions for influencing the distribution of benefits within the organization. the distribution of benefits within the organization.

It is the influence cost that is made out of the followings:It is the influence cost that is made out of the followings:     -- “Direct costs of influencing the activities (e.g., the time consumed by a “Direct costs of influencing the activities (e.g., the time consumed by a

division manager lobbying central management to overturn a decision that division manager lobbying central management to overturn a decision that is unfavorable to his or her divisionis unfavorable to his or her division).”).”[i]

[i] Besanko et al. Op. cit., p. 87 Besanko et al. Op. cit., p. 87

-- “The costs of bad decisions that arise from influence activities (…).” “The costs of bad decisions that arise from influence activities (…).”[i][i] Ibid. p. 87 Ibid. p. 87

Costs of Using the MarketCosts of Using the Market

A. Coordination of decision flows through the vertical chain.A. Coordination of decision flows through the vertical chain. Successful Successful decision-making process through the vertical chain, influencing the flows of decision-making process through the vertical chain, influencing the flows of information and material resources, depends on:information and material resources, depends on:

Efficient coordination between the different steps within the vertical Efficient coordination between the different steps within the vertical chain.chain.

B. “Leakage of Private Information”B. “Leakage of Private Information” Firms risk loosing private Firms risk loosing private information when making contractual arrangements with market firms. information when making contractual arrangements with market firms.

C. Transaction Cost.C. Transaction Cost. It is a “cost incurred in making an economic It is a “cost incurred in making an economic exchange.”exchange.”[i] [i] Wikipedia – The Free Enciclopedia, 2005. Available from: Wikipedia – The Free Enciclopedia, 2005. Available from: http://en.wikipedia.org/wiki/Transaction_costhttp://en.wikipedia.org/wiki/Transaction_cost

The Nature of the FirmThe Nature of the Firm Why firms exist? Wouldn’t be more appropriate to have contractual Why firms exist? Wouldn’t be more appropriate to have contractual

arrangements between self-employed persons? arrangements between self-employed persons? ““(…) search and information costs, bargaining costs, keeping trade secrets, (…) search and information costs, bargaining costs, keeping trade secrets,

and policing and enforcement costs” are all different kinds of transaction and policing and enforcement costs” are all different kinds of transaction costs. These all add up to the initial cost of goods of services. Firms emerge costs. These all add up to the initial cost of goods of services. Firms emerge when the production of certain goods or services might be performed when the production of certain goods or services might be performed internally and, consequently, having some transaction costs reduced.internally and, consequently, having some transaction costs reduced.

Company grows as a result of “finding the optimal balance between the Company grows as a result of “finding the optimal balance between the competing tendencies of the costs outlined above.”competing tendencies of the costs outlined above.”[i] [i] Ibid. Ibid.

There might be several There might be several stages of firm’s lifestages of firm’s life as outlined bellow: as outlined bellow:             The first stageThe first stage occurs when firms actually emerge due to a more occurs when firms actually emerge due to a more

efficient use of internal resources. At this stage, some transaction costs might efficient use of internal resources. At this stage, some transaction costs might be avoided by choosing to produce a certain product “in-house” instead of be avoided by choosing to produce a certain product “in-house” instead of having it supplied based on a contractual arrangement in the market. having it supplied based on a contractual arrangement in the market.

            The second stageThe second stage takes place when the firm grows. It means that the takes place when the firm grows. It means that the company found out the optimal balance between the two competing company found out the optimal balance between the two competing categories of costs, i.e. transaction cost and the cost associated with categories of costs, i.e. transaction cost and the cost associated with “decreasing returns to the entrepreneur function”.“decreasing returns to the entrepreneur function”.

            The third stageThe third stage occurs when the firm reached its peak and started to occurs when the firm reached its peak and started to fall. At this stage the costs associated with “decreasing returns to the fall. At this stage the costs associated with “decreasing returns to the entrepreneur function”entrepreneur function”[i] started to overcome the transaction costs. The firm started to overcome the transaction costs. The firm reached an adjourning phase. The growing phase reached a peak and firm reached an adjourning phase. The growing phase reached a peak and firm move to a decreasing phase.move to a decreasing phase.

[i] Ibid. Ibid. Firms exist because the conditions of a competitive market are reproduced Firms exist because the conditions of a competitive market are reproduced

within the organization at a lower cost comparing to market conditions.within the organization at a lower cost comparing to market conditions. Managing long-term contract arrangements with different stakeholders Managing long-term contract arrangements with different stakeholders

create the conditions for cost savings due to cost redistribution on a portfolio create the conditions for cost savings due to cost redistribution on a portfolio of long-term contracts.of long-term contracts.

Organizing Vertical Boundaries of the FirmOrganizing Vertical Boundaries of the Firm

Firms can either choose to organize in-house required supportive operations Firms can either choose to organize in-house required supportive operations or enter into market transactions with specialized organizations supplying or enter into market transactions with specialized organizations supplying certain specialized functions. Organizations can, also, integrate some or all of certain specialized functions. Organizations can, also, integrate some or all of its supportive functions along its vertical chain. its supportive functions along its vertical chain.

Companies choosing to organize one or more specialized supportive functions Companies choosing to organize one or more specialized supportive functions internally are advantaged in terms of costs relative to the situation when they internally are advantaged in terms of costs relative to the situation when they would have rather chosen to enter into transactions with a specialized market would have rather chosen to enter into transactions with a specialized market firm. The reason is that the perceived cost related to the developing and firm. The reason is that the perceived cost related to the developing and organizing some supportive functions (e.g. HR and accounting) is less than organizing some supportive functions (e.g. HR and accounting) is less than the cost paid for specialized services provided by market firms.the cost paid for specialized services provided by market firms.

On the other hand, firms choosing to have some supportive functions supplied On the other hand, firms choosing to have some supportive functions supplied by specialized market firms are advantaged in terms of costs comparing with by specialized market firms are advantaged in terms of costs comparing with the effort paid for having these specialized functions developed and organized the effort paid for having these specialized functions developed and organized “in-house”.“in-house”.

The decision to either have some functions outsourced or organized internally The decision to either have some functions outsourced or organized internally depends on the cost advantage of each option related to the other.depends on the cost advantage of each option related to the other.

Technical Efficiency and Agency EfficiencyTechnical Efficiency and Agency EfficiencyTechnical EfficiencyTechnical Efficiency A firm is technically efficient when using “the least-cost production process.”A firm is technically efficient when using “the least-cost production process.”

[i]. . – Example: Some successful retailers are technically efficient as they managed to Example: Some successful retailers are technically efficient as they managed to

use the least-cost sourcing and selling processes. Value-for-money retailers use the least-cost sourcing and selling processes. Value-for-money retailers secured their profit margins by using the least-cost sourcing and selling processes secured their profit margins by using the least-cost sourcing and selling processes and capabilities.and capabilities.

[i][i] Besanko et al. Op. cit., p. 134 Besanko et al. Op. cit., p. 134Agency EfficiencyAgency Efficiency ““Agency efficiency refers to the extent to which the exchange of goods and Agency efficiency refers to the extent to which the exchange of goods and

services in the vertical chain has been organized to minimize the coordination, services in the vertical chain has been organized to minimize the coordination, agency, and transaction costs (…)”agency, and transaction costs (…)”[i][i]

[i][i] Besanko et al. Op. cit., p. 134Besanko et al. Op. cit., p. 134 Firms failing to minimize transaction costs do not achieve agency Firms failing to minimize transaction costs do not achieve agency

efficiency.efficiency.[i][i] Failing to achieve agency efficiency is similar to failing to Failing to achieve agency efficiency is similar to failing to manage efficiently the exchange process of goods and services along the manage efficiently the exchange process of goods and services along the vertical chain.vertical chain.[i][i] See Besanko et al. Op. cit. See Besanko et al. Op. cit.

Asset Ownership and Vertical Boundaries Asset Ownership and Vertical Boundaries of the Firmof the Firm

Owning assets and controlling different steps along the vertical chain can Owning assets and controlling different steps along the vertical chain can make the difference comparing vertical integration with market exchange. make the difference comparing vertical integration with market exchange. Some firms expanded vertically by taking control on other firm’s assets or Some firms expanded vertically by taking control on other firm’s assets or creating their own capabilities positioned upstream or downstream within the creating their own capabilities positioned upstream or downstream within the vertical chain. vertical chain. – For exampleFor example, PepsiCo developed relations with two types of bottlers, i.e. , PepsiCo developed relations with two types of bottlers, i.e.

independent bottlers and company-owned bottlers. PepsiCo has no direct control independent bottlers and company-owned bottlers. PepsiCo has no direct control over an independent bottler’s management. PepsiCo can, also, acquire one of its over an independent bottler’s management. PepsiCo can, also, acquire one of its independent bottlers. In this final case, PepsiCo has direct control over the independent bottlers. In this final case, PepsiCo has direct control over the management of the newly acquired bottler.management of the newly acquired bottler.[i][i]

[i][i] Ibid. Ibid. ““Sanford Grossman and Oliver Hart analyze three different organizational Sanford Grossman and Oliver Hart analyze three different organizational

arrangements:arrangements:             NonintegrationNonintegration             Forward integrationForward integration             Backward integration.”Backward integration.”[[i]i]

- - NonintegrationNonintegration refers to the situation when two units, unit 1 being upstream refers to the situation when two units, unit 1 being upstream of unit 2, are independent firms, each one being in control of its own assets. of unit 2, are independent firms, each one being in control of its own assets.

- - Forward integrationForward integration: unit 1 owns the assets of unit 2: “unit 1 forward : unit 1 owns the assets of unit 2: “unit 1 forward integrates into the function performed by unit 2 by purchasing control over integrates into the function performed by unit 2 by purchasing control over unit 2’s assets”.unit 2’s assets”.[ii][ii]

- - Backward integrationBackward integration: unit 2 owns the assets of unit 1: “unit 2 backward : unit 2 owns the assets of unit 1: “unit 2 backward integrates into the function performed by unit 1 by purchasing control over integrates into the function performed by unit 1 by purchasing control over unit 1’s assets”unit 1’s assets”[iii][iii]..

[i][i] Besanko et al. Op. cit., p. 144 Besanko et al. Op. cit., p. 144 [ii][ii] Ibid., p. 144 Ibid., p. 144 [iii][iii] Ibid., p. 144 Ibid., p. 144

In conclusion, firms’ decision processes depend on the way assets In conclusion, firms’ decision processes depend on the way assets are owned and controlled by different units regarded as organizations are owned and controlled by different units regarded as organizations performing different steps along the vertical chain. performing different steps along the vertical chain.