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
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.
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
Make-or-Buy Continuum
Vertical Chain of Production
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).
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
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
Vertical Integration and Profits
The suppliers 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.
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
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
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.

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 units performance is
difficult.
It is difficult to internally replicate the
incentives faced by market firms
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.
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
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
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


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
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
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.
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
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

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
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
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).
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
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
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 contractors investment in
manufacturing facility for making certain
advanced weapon systems
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 firms 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
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
1
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
2
Rents and Quasi-Rents
Rent is the minimum economic profit
needed to induce A to enter into this
agreement with B (
1
)
Quasi-rent is the economic profit in excess
on the minimum needed to retain A in the
selling relationship with B (
1
-
2
)
The Holdup Problem
Whenever
1
>
2
, 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
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
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
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
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