External Contracting

1
Topic 2

• External Contracting
• (aka Boundaries of the Firm)

2
Markets versus Firms

• If markets are so efficient, why are there firms?
• Coase different costs associated with
  transacting in a firm versus a market
• But what are these transactions costs?
• And what is a firm anyway?
• This is the key issue in the outsourcing debate

3
Defining Firms

• Legal definition
• Nexus of Contracts
• Are you part of MBS?
• Property Rights approach

4
Benefits of Ownership

• If you own an asset what rights does this give
  you?
• Residual rights of control
• Rights to residual returns

5
Residual Control Rights

• Constraints on your use of the asset
• contractual
• legal
• moral
• Example if you own a car, what variables can you
  control?

6
Residual Returns

• Owner of an asset can exclude others from using
  it
• Increases bargaining power (added value)
• Others are forced to negotiate with you
• Example outsourcing photocopying services
• if own copier, can fire worker
• if outsource, can only fire copying firm

7
Motivating Example

• Good requires a truck (the asset) for production
• Also, enhancing value are
• a shipper, S (who wants to ship goods)
• a trucker, T (does this) can take care or no
  care in maintaining truck
• there are many truckers who can take no care but
  this particular trucker is the only one that can
  take care

8
Effort and Value

• Benefit from extended truck life
• No Care trucks value is 50
• Care trucks value is 200
• Truckers effort cost of care
• Minimal care cost of 10
• High care cost of 100
• Marginal Benefit 150 gt 90 Marginal Cost
• Efficient to take care
• What happens under different ownership structures
  for the asset?

9
Shipper Ownership
Shipper
Truck
Trucker
10
Trucker Ownership
Shipper
Truck
Trucker
11
Joint Ownership
Shipper
Truck
Trucker
12
Third Party Ownership
Shipper
Truck
Trucker
13
Efficiency

• Does ownership matter for efficiency?
• Will any ownership structure lead to too little
  care?

14
Comparing Added Values
 
How to Share 100
 
15
Things to Note

• In each case, total value created is 100
• This is a maximum 200 - 100
• All that differs is distribution
• The owner of the asset is essential and hence,
  their added value is equal to total value created
• Asset owners have higher added value than other
  agents
• But the shipper is essential no matter what (in
  this example)

16
Coase Theorem

• If all relevant variables (i.e., effort) are
  contractible, then ownership of an asset only
  affects the distribution of value and not the
  value realised under each structure.

17
Markets for Ownership

• How much will outside party by willing to pay for
  the asset?
• Payoff (with ownership) Payoff (without)
  46.67
• How much will trucker be willing to pay for the
  asset?
• Payoff (with ownership) Payoff (without) 50
  - 6.67 43.33
• How much will shipper be willing to pay for the
  asset?
• Payoff (with ownership) Payoff (without) 70
  - 46.67 23.33
• Outside party will win any asset auction.

18
Misconceptions about Firm Boundaries

• Merging to realise scale economies
• outsourcing to allow others to realise scale
  economies
• Diversifying to realise scope economies
• or spinning off divisions to focus on core
  competencies
• Integrating to assure supply

19
Realising Scale Economies

• Example Ford supply of anti-lock brakes
• If Ford uses enough brakes (e.g., A), it gains
  no cost advantage in the market
• If Ford only uses A, could it gain by
  outsourcing?

AC
C
C
A
A
A
Q
20
Air services

• Largest companies still use regular airlines
• some purchase executive jets for special needs
• exploration companies need to transport special
  equipment
• The Kimberly-Clark paper company
• production facilities in a number of small towns
  in Wisconsin
• started an air service for its personnel
• this developed into Midwest Airlines

21
Realising Scope Economies

• Pharmaceutical industry in Australia
• Heavily regulated
• Retail end is fragmented and owned by independent
  pharmacist
• Scope economies of marketing and management
  services (branding etc.)
• Examples Mayne, Sigma, API etc.
• Contract these services rather than integrate

22
Supply Assurance

Supply/MC
As Demand
Bs Demand
Normal Demand
Q
23
Supply Assurance

As Demand
Supply/MC
Bs Demand
Peak Demand
Q
24
Integration

Supply/MC
Loss in value
Q
25
Summary

• What is a firm?
• Defined by ownership of assets
• Do changes in ownership matter?
• No, can always find a contracting option that
  creates the same value (efficiency)
• Yes, owners can negotiate more surplus
  (distribution) so they differ in their private
  value of ownership
• What are poor reasons to contemplate changes in
  firm boundaries? I.e., outsourcing or integration
• Economies of scale and scope
• Supply assurance

26
Case

• Nucleon Inc.

27
Options for Nucleon
28
Does Royalty Make Sense?

• Completely in-house
• At r 30, get NPV of 11.3m
• Contract and then in-house
• At r 30, get NPV of 13.4m
• Licensing ex ante
• NPV 5.3m based on 5
• Licensing ex post
• NPV 2 - 4 m (depending on I/II choice)

29
Phase III In-house

• Advantages
• Protect proprietary process know-how developed
  earlier
• Avoid technology transfer difficulties
• Accumulate skills and capabilities that may be
  valuable for future Nucleon product

• Disadvantages
• Nucleon has no prior experience with large scale
  manufacturing does it want to take all these
  risks with first product
• Process of building a manufacturing organisation
  will divert managements attention from RD

30
Phase I/II

• If not going to keep Phase III in-house, what
  advantages are there to building a pilot plant?
• With sub-contractor still have option to scale up
  later on.
• With licensing, there is no further option.

31
Looking Forward

• Transactions costs must play an important role in
  firm boundaries
• But what are the specific sources of these costs?
• Contracting difficulties
• Incomplete information