The Vertical Boundaries of the Firm

1
The Vertical Boundaries of the Firm Chapter 5
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The Vertical Chain of Production for Furniture
Processing and Handling

• Raw Inputs
• (trees, Iron, cows etc.)
• Transportation
• Intermediate Goods Processing
• (lumber milling, frame fabrication)
• Transportation and Warehousing
• Assemblers
• (furniture manufacture)

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The Make versus Buy Decision
Upstream-Downstream
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Benefits of Using the Market
Market firms can achieve economies of scale
MES versus organizational requirements
Use of specialized or proprietary technologies
Efficiencies resulting from competitive
market dynamics
Intangible benefits
Avoidance of agency and influence costs
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Costs of Using the Market
Poor coordination in the value chain
Reluctance of trading partners to share
valuable information
Transaction Costs
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Coordination of Production Flows Through the
Vertical Chain
Contracts and Coordination
Coordination is especially important when
design attributes are present
Design attributes are attributes that need to
relate to each other in a precise fashion
Timing fit
Size fit
RD fit
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Leakage of Private information
Private information can be a major source of
competitive advantage 
Use of the market can increase the risk of losing
control of proprietary information
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The Economic Foundations of Contracts
Complete versus Incomplete Contracts
Factors that prevent complete contracting
Bounded rationality
Difficulties in specifying performance
Asymmetric Information
Role of Contract Law Uniform Commercial Code
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Transaction Costs
Transaction An autonomous exchange of goods or
services between parties with no formal agreement
that the relationship will continue into the
future
Transactions Costs the costs arising from
organizing and transacting exchanges
Key Characteristics of Transaction Costs
Strong mutual reliance by each party after
agreement has been reached
Efforts by one or more parties to sweeten its
end of the deal
Inability to write enforceable contracts that
cover all contingencies and penalize shirking
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Relationship-Specific Assets
Relationship-specific assets (RSA) an investment
made to support a given transaction
Cannot be redeployed to another transaction
without some loss in productivity or adjustment
cost
RSA lock parties into a relationship to a certain
degree
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Forms of Asset Fixity
Site Specificity
Physical Asset Specificity
Dedicated Assets
Human Asset Specificity
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Rents and Quasi-Rents
Rents and Quasi-Rents are associated with
opportunity cost before (ex ante) and after (ex
post) the fundamental transformation
Rent the difference between the revenue the firm
receives and that which it must receive to enter
into a given relationship
Quasi-Rent the difference between (a) the
revenue the seller would actually receive if the
deal were completed according to the original
terms of a contract and (b) the revenue it must
receive to be induced to not exit the
relationship after a relationship-specific
investment has been made
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Rents and Quasi-Rents
Rent pQ-TVC-I   Quasi-Rent
pQ-TVC-S where p price Q quantity
produced TVC total variable cost I ex
ante opportunity cost of investment S ex post
opportunity cost of investment
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Example Rents and Quasi-Rents
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The Holdup Problem
The holdup problem arises when a party to a
contractual relationship exploits the other
partys vulnerability due to a relationship-specif
ic asset.
Manifest in the redistribution of quasi rents
through
contractual negotiation unilateral actions by
one party at the expense of another 
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The Holdup Problem and Transactions Costs
The holdup problem increases transaction costs in
four ways
Increased difficulty in contract negotiations and
more frequent renegotiations
Investment to improve ex post bargaining
positions
Distrust
Reduced investment in relationship-specific
investments