ECP 6701

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ECP 6701 Competitive Strategies in Expanding
Markets
Vertical Boundaries of the Firm
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Readings

• BDSS Chapter3

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Vertical Chain

• Begins with the acquisition of raw materials
• Ends with the sale of finished goods/services
• Includes support services such as finance and
  marketing
• Organizing the vertical chain is an important
  part of business strategy

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Vertical Boundaries of the Firm

• Which steps of the vertical chain are to be
  performed inside the firm?
• Which steps of the vertical chain to be
  out-sourced?
• Choice between the invisible hand of the market
  and the visible hand of the organization (Make
  or Buy)

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Make versus Buy

• Decision depends on the costs and benefits of
  using the market as opposed to performing the
  task in-house
• Outside specialists may perform a task better
  than the firm can
• Intermediate solutions are possible (Examples
  Strategic alliances with suppliers, Joint
  ventures)

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Support Services

• Accounting
• Finance
• Legal Support
• Marketing
• Planning
• Human Resource Management

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Defining Boundaries

• Firms need to define their vertical boundaries
• Considerations
• Economies of scale achieved by market firms
• Value of market discipline
• Ease of coordination of production flows in-house
  
• Transactions costs when dealing with market firms

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Reasons to Buy rather than Make

• Market firms (outside specialists) may have
  patents/proprietary information that makes low
  cost production possible
• Market firms can achieve economies of scale that
  in-house units cannot
• Market firms are subject to market discipline,
  whereas in-house units may be able to hide their
  inefficiencies behind overall corporate success
  (Agency and influence costs)

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Economies of Scale
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Economies of Scale

• A given manufacturer of automobiles may not be
  able to reach the minimum efficient scale (A)
  for anti-lock brakes
• An outside supplier may reach the minimum
  efficient scale by supplying to different
  automobile manufacturers

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Economies of Scale

• An automobile manufacturer would rather buy
  anti-lock brakes from an independent supplier
  than from a competitor
• Minimum efficient scale may be feasible for the
  independent supplier but not for an automobile
  manufacturer

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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

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Agency and Influence Costs

• The incentives to be efficient and innovative are
  weaker when a task is performed in-house
• Agency costs are particularly problematic if the
  task is performed by a cost center within an
  organization
• It is difficult to internally replicate the
  incentives faced by market firms

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Influence costs

• In addition to agency costs, performing a task
  in-house will lead to influence costs as well
• Internal Capital Markets allocates scarce
  capital
• Allocations can be favorably affected by
  influence activities
• Resources consumed by influence activities
  represent influence costs

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Reasons to Make

• Costs imposed by poor coordination
• Reluctance of partners to develop and share
  valuable private information
• Transactions cost that can be avoided by
  performing the task in-house
• Each problem can be traced to difficulties in
  contracting

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Role of Contracts

• Firms often use contracts when certain tasks are
  performed outside the firm
• Contracts list
• the set of tasks that need to be performed
• the remedies if one party fails to fulfill its
  obligation

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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

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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
• One should be able to map from each possible
  contingency to a set of actions
• One should be able to define and measure
  performances
• One should be able to enforce the contract

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Complete Contract (Continued)

• 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

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Incomplete Contracts

• Incomplete contracts
• Involve some ambiguities
• Need not anticipate all possible contingencies
• Do not spell out rights and responsibilities of
  parties completely

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Factors that Prevent Complete Contracting

• Bounded rationality
• Difficulties in specifying/measuring performance
• Asymmetric information

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Bounded Rationality

• Individuals have limited capacity to
• Process information
• Deal with complexity
• Pursue rational aims
• Individuals cannot foresee all possible
  contingencies

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Specifying/Measuring Performance

• Terms like normal wear and tear may have
  different interpretations
• Performance cannot always be measured
  unambiguously

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Asymmetric Information

• Parties to the contract may not have equal access
  to contract-relevant information
• One party can misrepresent information with
  impurity

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Contract Law

• Contract law facilitates transactions with
  incomplete contracts
• Parties need not specify provisions that are
  common to a wide class of transactions

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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

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Coordination of Production Flows

• For successful coordination one party needs to
  make decisions that depend on the decision made
  by others
• A good fit should be accomplished in several
  dimensions. Some examples are
• Timing
• Size
• Color
• Sequence

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Coordination Problems

• Without good coordination, bottlenecks arise in
  the vertical chain
• Coordination is especially important when design
  attributes are present
• To ensure coordination, firms rely on contracts
  that specify delivery dates, design tolerances
  and other performance targets

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Leakage of Private Information and Outsourcing

• Firms would not want to compromise the source of
  their competitive advantage
• 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

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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

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Transactions Costs

• Outsourcing entail costs of negotiating, writing
  and enforcing contracts
• Costs are incurred due to opportunistic behavior
  of parties to the contract and efforts to prevent
  such behavior
• Transactions costs explain why economic
  activities occur outside the price system

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Transactions Costs

• Sources of transactions costs
• Investments that need to be made in relationship
  specific assets
• Possible opportunistic behavior after the
  investment is made (hold up problem)
• Quasi-rents (magnitude of hold up problems)

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Relationship-Specific Assets

• Relation-specific assets are essential for a
  given transaction
• These assets cannot be redeployed for another
  transaction costlessly
• Once the asset is in place, the other party to
  the contract cannot be replaced costlessly,
  because the parties are locked into the
  relationship to some degree

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Relationship-Specific Assets Examples

• An aluminum refiner invests in a refinery
  designed to process a particular grade of bauxite
  ore
• The French government invests in transportation
  infrastructure for Euro-Disney

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Forms of Asset Specificity

• Relation-specific assets may exhibit different
  forms of specificity
• Site specificity
• Physical asset specificity
• Dedicated assets
• Human asset specificity

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Rent and Quasi-rent

• 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 form an alternate transaction

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Rent and Quasi-rent

• 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 p1
• If A were to renege on the agreement and B is
  forced to sell its output in the open market, the
  economic profit will be p2

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Rent and Quasi-rent

• Rent is the minimum economic profit needed to
  induce A to enter into this agreement with B (p1)
• Quasi-rent is the economic profit in excess on
  the minimum needed to retain A in the selling
  relationship with B (p1- p2)

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The Holdup Problem

• Whenever p1 gt p2, 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-specifi
  c assets, quasi-rent may exist and lead to the
  holdup problem

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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 relation
  specific assets

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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

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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

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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

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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

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Asset Specificity and Transactions Costs

• 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

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Summary

• Production activities flow from upstream
  suppliers to downstream manufacturers,
  distributors, and retailers (vertical chain).
• The make or buy problem determines the vertical
  boundaries of a firm.
• The solution to this problem depends on option
  leads to most efficient production.
• This requires an assessment of the cost and
  benefits of using the market.

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Summary

• Market firms can exploit economies of scale to
  produce a component cheaper.
• Market firms are subject to competition which
  encourages efficiency and innovation.
• Vertically integrated firms might face agency and
  influence costs.

48
Summary

• Use of market transactions entails coordination
  problems (especially for production of inputs
  with complex design requirements).
• Use of market transactions may lead to lose
  control of valuable private information.
• Use of market transaction might entail
  contracting costs.