Transactions Costs and the Scope of the Firm

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Transactions Costs and the Scope of the Firm
Which is more efficient several specialist
firms linked by markets, or the combination of
these specialist firms under common ownership.
VERTICAL PRODUCT GEOGRAPHICAL
AREAS SINGLE V1 P1
P2 P3 A1 A2 A3 FIRM
V2 V3 SEVERAL V1
P1 P2 P3
A1 A2 A3 SPECIALIZED V2 FIRMS
V3 Common Issue--- What are TRANSACTION COSTS
of markets compared with administrative costs of
the firm?
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Introduction (cont.)

• Types of Diversification
• Vertical integration
• Strategy of acquiring control over additional
  links in value chain of producing and delivering
  products/services.
• Backward integration
• Moving closer to sources of raw materials by
  acquiring resource suppliers or manufacturing the
  components needed for production of final
  product.
• Forward Integration
• Just the opposite moving closer to end-user
  (acquire retail outlets for distribution, etc.).

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Exhibit Vertical Integration
Backward Integration
Forward Integration
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Determinants of Changesin Corporate Scope

• 1800 - 1975 Expansion in size scope of
  biggest industrial corporations. Administrative
  costs of firms fell due to
• Advances in transportation, information and
  communication technologies
• Advances in management - accounting systems,
  decision sciences, financial techniques,
  organizational innovations, scientific management

1975 - 1995 Contraction in size scope of
biggest industrial corporations. Increased
market turbulence, more competition, accelerated
technological change Need for speed,
flexibility, responsiveness Large, complex
corporations become relatively less efficient
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The Costs and Benefits of Vertical Integration
BENEFITS

• Technical economies from integrating processes
  e.g. iron and steel production
• -- but doesnt necessarily require common
  ownership
• Superior coordination
• Avoids transactions costs of market contracts
  from
• -- small numbers of firms
• -- transaction-specific investments
• -- opportunism and strategic misrepresentation
• -- taxes and regulations on market transactions

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Introduction (cont.)

• Advantages of vertical integration
• Greater control over costs and supply of
  components.
• Avoids the transaction costs associated with
  dealing with vendors or retailers.
• Ability to protect proprietary technology.
• Ability to maintain or cultivate a companys
  reputation for outstanding quality or service.

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The Costs and Benefits of Vertical Integration
COSTS

• Differences in optimal scale of operation between
  different stages prevents balanced VI
• Strategic differences between different vertical
  stages creates management difficulties
• Inhibits development of and exploitation of core
  competencies
• Limits flexibility -- in responding to demand
  cycles
• -- in responding to changes in
  technology,
• customer preferences, etc.
• (But VI may be conducive to system-wide
  flexibility)
• Compounding of risk

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Introduction (cont.)

• Disadvantages of vertical integration
• Higher fixed overhead costs.
• Integrated firms must deal with transfer price
  dilemma which can create serious morale and other
  internal problems.
• Demand uncertainty creates problems.
• Low demand can lead to underutilization of plant
  capacity.
• High demand can result in dependence on outside
  suppliers.
• Technological change can leave these firms stuck
  with old technology.

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When is Vertical Integration More Attractive than
Outsourcing?

• How many firms are available The fewer the
  companies
• to undertake the activities? the more
  attractive is VI
• Is transaction-specific investment If yes, VI
  more attractive needed?
• Does limited information permit VI can limit
  opportunism cheating?
• Are taxes or regulation imposed VI can avoid
  them on transactions?
• Do the two stages have similar Greater the
  similarity, the optimal scale of
  operation? more attractive is VI
• Are the two stages strategically Greater the
  strategic similar? similarity
  ---the more attractive is VI
• How uncertain is market demand? Greater the
  unpredictability ----the more costly is VI
• Does VI increase risk? If heavy investment
  required and risks between stages
  are inter- related----VI increases risk.
  

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Designing Vertical Relationships Long-Term
Contracts and Quasi-Vertical Integration

• Intermediate between spot transactions and
  vertical integration are several types of
  vertical relationships
• ---such relationships may combine benefits of
  both market transactions and internalization
• Key issues in designing vertical relationships
• -- How is risk allocated between the parties?
• -- Are the incentives appropriate?

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Recent Trends in Vertical Relationships

• From competitive contracting to supplier
  partnerships, e.g. in autos
• From vertical integration to outsourcing (not
  just components, also IT, distribution, and
  administrative services).
• Diffusion of franchising
• Technology partnerships (e.g. IBM- Apple Canon-
  HP)
• Inter-firm networks
• General conclusion- boundaries between firms
  and markets becoming increasingly blurred.

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Different Types of Vertical Relationship
Low Degree of Commitment High
Low
Informal supplier/ customer relationships
Vertical integration
Supplier/ customer partnerships
Spot sales/ purchases
Formalization
Joint ventures
Agency agreements
Franchises
Long-term contracts
High
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The Internationalization of Industries
The Process of Internationalization
International Global Industries
Industries --aerospace --automobiles
--military hardware --oil --diamond mining
--semiconductors --agriculture --consumer
electronics Domestic Multinational/
Industries Multidomestic --railroads
Industries --laundries/dry cleaning
--retail banking --hairdressing --hotels
--milk --consulting
HIGH
International Trade
LO W
LOW
HIGH
Foreign Direct Investment
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Implications of Internationalizationfor Industry
Analysis

• INDUSTRY STRUCTURE
• Lower entry barriers around national markets
• Increased industry rivalry --- lower seller
  concentration
• --- greater diversity of competitors
• Increased buyer power wider choice for dealers
  consumers

• COMPETITION
• Increased intensity of competition

• PROFITABILITY
• Other things remaining equal,
  internationalization tends to reduce an
  industrys margins rate of return on
  capital

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Analyzing Competitive Advantage within an
International Context The Basic Framework
THE INDUSTRY ENVIRONMENT Key Success Factors
FIRM RESOURCES CAPABILITIES -- Financial
resources -- Physical resources -- Technology --
Reputation -- Functional capabilities -- General
management capabilities
COMPETITIVE ADVANTAGE
THE NATIONAL ENVIRONMENT -- National resources
and capabilities (raw materials national
culture human resources transportation,
communication legal infrastructure --
Domestic market conditions -- Government
policies -- Exchange rates -- Related and
supporting industries
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National Influences on Competitiveness The
Theory of Comparative Advantage

• A country is relatively efficient in the
  production of those products which make intensive
  use of resources which are relatively abundant
  within the country. E.g.
• Philippines relatively more efficient in the
  production of footwear, apparel, and assembled
  electronic products than in the production of
  chemicals and automobiles.
• U.S. is relatively more efficient in the
  production of semiconductors and
  pharmaceuticals than shoes or shirts.
• When exchange rates are well-behaved,
  comparative advantage emerges as competitive
  advantage.

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Porters Competitive Advantage of Nations

• Extends and modifies traditional theory of
  comparative advantage to take account of the
  following factors
• Competitive advantage is about companies --- the
  importance of the national environment is
  providing a home base for the company.
• Sustained competitive advantage depends upon
  dynamic factors-- innovation and the upgrading of
  firms resources and capabilities
• The critical role of the national environment is
  its influence upon the dynamics of innovation and
  upgrading.

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Porters National Diamond Framework

• 1. FACTOR CONDITIONS. Home grown resources and
  capabilities more important than natural
  endowments.
• 2. RELATED AND SUPPORTING INDUSTRIES.
  Competitive advantage occurs in industry
  clusters (e.g. semiconductors-computers-software
  in the U.S.).
• 3. DEMAND CONDITIONS. Discerning domestic
  customers drive quality and innovation (e.g.
  Japanese camera industry)
• 4. STRATEGY, STRUCTURE, RIVALRY. E.g. domestic
  rivalry drives innovation and upgrading.

FACTOR CONDITIONS
RELATING AND SUPPORTING INDUSTRIES
DEMAND CONDITIONS
STRATEGY, STRUCTURE, AND RIVALRY
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Consistency Between Strategy and National
Conditions

• In globally-competitive industries, firm
  strategy needs to take account of national
  conditions
• U.S. textile manufacturers must compete on the
  basis of advanced process technologies and focus
  on high quality, less price-sensitive market
  segments
• Malaysian semiconductor manufacturers can be
  competitive in high volume, less technologically
  advanced items (e.g. memory chips)
• Dispersion of value chain to exploit different
  national environments (e.g. Nike RD in U.S.,
  components in Korea and Taiwan, assembly in
  China, Thailand and India, marketing in Europe
  and North America)

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International Location of Production

• 3 considerations
• National resource conditions What are the major
  resources which the product requires? Where are
  these available at low cost?
• Firm-specific advantages to what extent is the
  companys competitive advantage based upon
  firm-specific resources and capabilities, and are
  these transferable?
• Tradability issues Can the product be
  transported at economic cost? If not, or if trade
  restrictions exist, then production must be close
  to the market.

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International Location of Industrial Activities
within the Value Chain
Where is the optimal location of X in terms of
the cost and availability of inputs?
The optimal location of activity X
considered independently
What government incentives/ penalties affect the
location decision?
What internal resources and capabilities does the
firm possess in particular locations?
WHERE TO LOCATE ACTIVITY X?
What is the firms business strategy (e.g. cost
vs. differentiation advantage)?
The importance of links between activity X
and other activities of the firm
How great are the benefits of linkages through
proximity?
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Overseas Market Entry Alternative Modes

• TRANSACTIONS DIRECT INVESTMENT
• Exporting Exporting Exporting Licensing
  Franchising Joint
  Wholly owned
• Spot Long-term with foreign
  technology venture
  subsidiary
  
• trans- contract distributor/
  and Marketing
  Fully Marketing Fully
• actions agent trademarks
  distribution integral- sales
  integral-
• only ted only
  ted
• Key issues
• Is the firms competitive advantages based upon
  firm-specific or country-specific resources and
  capabilities?
• Is the product tradable and what are the barriers
  to/ costs of trade?
• Does the firm possess the full range of resources
  and capabilities needed to serve the overseas
  market?

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Introduction (cont.)

• Global diversification
• Usually motivated by desire to grow (Boeing,
  Kelloggs, Caterpillar).
• Simplest route is exporting.
• Others include licensing or franchising.
• Most complex route is to establish wholly-owned
  subsidiaries.

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Introduction (cont.)

• Challenges in global diversification
• Most difficult challenge is to appreciate the
  unique cultures and customs of foreign markets.
• Need for products to be adapted to accommodate
  these markets.

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Alliances and Joint Ventures Management Issues

• Benefits ability to combine different resources
  and capabilities of separate partners, ability to
  learn from one another.
• Problems management differences between the two
  partners. Conflict potential greatest where the
  partners are also competitors.
• Collaborating with competitors benefits seldom
  shared equally. Determinants of distribution of
  benefits
• Strategic intent of the partners- which partner
  has the clearer vision of the purpose of the
  alliance?
• Appropriability of the contribution-- which
  partners resources and capabilities can more
  easily be captured by the other?
• Absorptive capacity of the company-- which
  partner is the more receptive learner?

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Multinational Strategies Globalization versus
National differentiation

• The case for a global strategy
• National preferences in decline-- possible to
  view the
• world becoming a single, if segmented, market.
• Access to global scale economies--cost savings in
  purchasing, manufacturing, product development
  and marketing.
• Strategic strength from global positioning-- but
• locating in multiple national markets, by
  locating in multiple national markets, the
  global competitor can cross-subsidize
  to attack nationally focused rivals.
• Need to access market trends and technological
• developments in each of the worlds major
  economic
• centers- N. America, Europe, EastAsia.

Ted Levitt Global- -ization Thesis
Hamel Prahalad Thesis
Kenichi Ohmaes Triad Power Thesis
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Strategy and Organization of the MNCThe
Evolution of Multinational Strategies and
Structures (1) Pre 2nd WW Era of the Europeans

• The European MNC as Decentralized Federation
• National subsidiaries self-sufficient and
  autonomous
• Parent control through appointment of
  subsidiaries senior management
• Organization and management systems reflect
  conditions of transport and communications at the
  time e.g. Unilever, Phillips, Courtaulds, Royal
  Dutch/Shell.

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Strategy and Organization of the MNC The
Evolution of Multinational Strategies and
Structures (2) Post 2nd WW U.S. Dominance

• American MNCs as Coordinated Federations
• National subsidiaries fairly autonomous
• Dominant role as U.S. parent-- especially in
  developing new technology and products
• Parent-subsidiary relations involved flows of
  technology and finance, and appointment of top
  management.e.g. Ford, GM, Coca Cola, IBM

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Strategy and Organization of the MNC The
Evolution of Multinational Strategies and
Structures (3) 1970s and 1980s The Japanese
Challenge

• The Japanese MNC as Centralized Hub
• Pursuit of global strategy from home base
• Strategy, technology development, and manufacture
  concentrated at home
• National subsidiaries primarily sales and
  distribution companies with limited autonomy.
  e.g. Toyota, NEC, Matsushita

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Matching Global Strategies and Structures to
Industry Conditions

• Degree of globalization depends upon the benefits
  of global
• integration versus the benefits of national
  differentiation.
• Key issue --How important are global scale
  economies?
• --How different are customer
  requirements between countries?

• Jet engines

Benefits of global integration

• Consumer
• electronics

• Telecommunications
• equipment

• Packaged
• grocery products

• Cement

Benefits of national differentiation

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Marketing Global Strategies and Situations to
Industry Conditions Firm Success in Different
Industries

• Consumer Electronics Branded, Packaged
  Telecommunications
• Consumer Goods Equipment
• - Global industry -
  Substantial national - Requires both global
• - Matsushita the most
  differentiation, few global integration
  and national
• successful
  scale economies differentiation.
• - Philips the survivor - Kao
  has limited success - NEC only partially
• - GE sold out
  outside Japan successful -
  Unilever and PG most - ITT sold out
  successful - Ericsson most
  successful

Matsushita
NEC
Kao
Erickson
Philips
global integration
global integration
global integration
PG
Unilever
General Electric
ITT
local responsiveness local
responsiveness local responsiveness
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Reconciling Global Integration with National
Differentiation The Transnational Corporation
Tight complex controls and coordination and a
shared strategic decision process.
Heavy flows of technology, finances, people, and
materials between interdependent units.

• The Transnational an integrated network of
  distributed interdependent resources and
  capabilities.
• Each national unit and source of ideas, skills
  and capabilities that can be harnessed to
  benefit whole corporation.
• National units become world sources for
  particular products, components, and activities.
• Corporate center involved in orchestrating
  collaboration through creating the right
  organizational context.