Economics of Strategy

1
Economics of Strategy
Besanko, Dranove, Shanley and Schaefer, 3rd
Edition
Chapter 4 Organizing Vertical Boundaries Vertica
l Integration and its Alternatives
Slide show adapted on basis of that prepared by
Richard PonArul California State University,
Chico
? John Wiley ? Sons, Inc.
2
Introduction

• There are various approaches in considering the
  merits of vertical integration
• balancing transactions costs (O. Williamson)
• role of asset ownership (S.Grossman, O.Hart,
  J.Moore)
• These two approaches generate also two different
  theories of the firm
• There are also alternatives to vertical
  integration
• tapered integration
• joint ventures
• networks
• implicit contracts

3
Vertical Boundaries

• For each step in the vertical chain the firm has
  to decide between market exchange and vertical
  integration
• The degree of vertical integration differs
• Across industries
• Across firms within an industry
• Across transactions with in firm
• We consider an upstream firm and a downstream
  firm

4
The Tradeoff in Vertical Integration

• Using the market improves technical efficiency
  (least cost production) it
  relates to production
• Vertical integration improves agency efficiency
  (coordination, transactions costs) it relates
  to exchange
• Firm should economize - choose the best
  possible combination of technical and agency
  efficiencies

5
Technical Efficiency

• Using the market leads to higher technical
  efficiency compared to vertical integration
  (power of market discipline)
• The difference in technical efficiency of market
  over vertical integration (?T) depends on the
  nature of the assets involved in production (ie.
  production of the intermediate product by the
  upstream firm)

6
Technical Efficiency

• As the assets become more specialized the market
  firms economies of scale become weaker
• The difference in technical efficiency of market
  over vertical integration (?T) declines with
  greater asset specificity

7
Agency Efficiency

• At high levels of asset specificity, differential
  agency efficiency of market over vertical
  integration (?A) is negative
• When specialized assets are involved, potential
  for a holdup is high and the result is higher
  transactions costs

8
Agency Efficiency

• At low levels of asset specificity, differential
  agency efficiency of market over vertical
  integration (?A) is likely to be positive
• Without the holdup problem, market exchange could
  be more agency efficient than in-house production
  (due to intra-firm agency and influence costs).

9
Efficiency Tradeoff

• The combined (market over vertical integration)
  differential efficiency (?C) will be negatively
  related to asset specificity
• At high levels of assets specificity vertical
  integration is more efficient
• At low levels of assets specificity outsourcing
  wins

10
An illustration
If the input is purchased from an outside
supplier agency costs include negotiation,
writing and enforcing contracts
If the input is sourced internally agency
costs are the agency and influence costs
discussed before
Vertical integration is preferable when
economies of scale are weak and asset
specificity is high
k measures asset specificity

When the degree of asset specificity is low DA gt 0
DT gives the difference in minimum production
cost from internal versus external production
When the degree of asset specificity is greater
than k vertical integration is the preferred
mode
When the degree of asset specificity is less
than k market exchange is the preferred mode
When the degree of asset specificity is high DA
lt 0
DA gives the difference in agency costs from
internal versus external production
DT
k
k
k
DC is the vertical sum of DT and DA. It is the
difference between production and exchange costs
with vertical integration and these costs with
market exchange
When the degree of asset specificity is less
than k market exchange has lower transactions
costs
DC
DA
11
Technical and Agency Efficiency
12
Efficiency Tradeoff and Scale

• When the scale of production of the downstream
  firm increases, the vertically integrated firm
  enjoys better economies of scale
• With increased scale, the differential technical
  efficiency decreases for every level of asset
  specificity (the ?T curve shifts downward)

13
Efficiency Tradeoff and Scale

• With an increase in scale, the differential
  agency efficiency becomes more sensitive to asset
  specificity
• Differential agency efficiency (market over
  vertical integration) will increase with scale
  for low asset specificity
• With high asset specificity, differential agency
  efficiency decreases with scale
• ? ?A curve twists clockwise through point k

14
Efficiency Tradeoff and Scale

• The combined differential efficiency (?C) sharply
  declines for low asset specificity
• ? ?C curves shifts downward and becomes less
  steep
• The degree of asset specificity at which market
  is just competitive with vertical integration
  declines (from k to k)
• Vertical integration is preferred to market
  exchange over a larger range of asset specificity

15
The illustration (cont.)
An increase in market size reduces the critical
degree of asset specificity above which vertical
integration is preferred
Now consider the impact of market growth on the
internal/external choice

An increase in market size causes DT to fall
k
An increase in market size accentuates the
advantage of the mode of production with lower
exchange costs and so twists DA around k
DT
k
k
k
The overall effect is to change DC and move k
to the left to k
DC
DA
16
Vertical integration (cont.)

• Three important conclusions
• Scale and scope economies at intermediate input
  level
• gain less from vertical integration when scale
  and scope economies are strong
• Product market scale and growth
• gain more from vertical integration in large and
  growing markets
• Asset specificity
• gain more from vertical integration when
  production involves investment in
  relationship-specific assets

17
Real-World Evidence

• GM is more vertically integrated than Ford is,
  for the same asset specificity (scale)
• In aerospace, greater design specificity
  increases the likelihood of vertical integration
  of production
• Among utilities, mine-mouth plants are more
  likely to be integrated compared with other plants

18
The Virtual Corporation (Davidow-Malone, 1992)

• Advances in technology have reduced coordination
  costs and reduced asset specificity
• Consequently, the advantage of market over
  vertical integration has steadily increased
• Virtual corporation is the limit when each
  element in the vertical chain will be independent

19
Vertical Integration and Asset Ownership

• Grossman-Hart-Moore (GHM) adopt a different
  approach to study vertical integration
• Make-or-buy decision is essentially a decision
  regarding ownership rights if right of use is
  granted the owner retains residual rights of
  control (i.e.. Rights of control on what is not
  explicitly stipulated on the contract)
• cont.

20
Vertical Integration and Asset Ownership

• If contracts were complete, it will not matter
  who owned the assets in the vertical chain
• With incomplete contracts, ownership pattern
  determines the willingness of each party to make
  relationship-specific investments

21
Vertical Integration and Asset Ownership

• Three ways to organize a transaction in the
  vertical chain
• The two units are independent (non integration)
• Upstream unit owns the assets of the downstream
  unit (forward integration)
• Downstream unit owns the assets of the upstream
  unit (backward integration)

22
Asset Ownership and Integration

• Possession of residual control improves
  bargaining power over operating decision
• The form of integration affects the incentives to
  invest in relationship-specific assets
• Whether vertical integration is optimal or not
  depends on the relative contribution to value
  added by each partys investment

23
Asset Ownership and Integration

• If the investments by the upstream player and the
  downstream player are of comparable importance,
  market exchange is preferred
• If the investment by one player is more important
  in value creation, vertical integration is
  preferred

24
Asset Ownership and Integration

• Asset ownership is an important dimension of
  vertical integration
• There could be degrees of integration depending
  on the extent of control over specialized assets
• Example Auto manufacturers can use independent
  suppliers for body parts but own the dies and
  stamping machines

25
Vertical Integration in Insurance Industry

• In whole life insurance, sales agents efforts in
  renewal are unimportant and insurers tend to use
  in-house sales forces and tend to own client
  lists
• In term life insurance, renewal efforts are more
  important and independent agents who own client
  lists are used

26
Human Assets and Vertical Integration

• When physical assets are involved, upstream (or
  downstream) asset ownership can be used along
  with market exchange
• When human assets are important, acquiring
  control of these assets can be done only through
  a full fledged vertical integration

27
Process Issues in Vertical Mergers

• The desirability of a vertical merger is affected
  by its impact on technical and agency efficiency
• It is also affected by governance issues
• managers of the acquired unit have to cede
  control post-merger
• but they must be given decision-making power
  commensurate with their control over specialized
  resources e.g. human capital
• decision-making rights should be given to
  managers with the greatest influence in
  performance and profitability
• if success depends on synergies associated with
  physical assets, centralize
• if success depends on specialized knowledge of
  acquired managers, decentralize

28
Process issues (cont.)

• The governance structure that emerges may well
  exhibit path dependence
• past circumstances determine governance structure
• immediate post-merger conflict undermines the
  potential for future cooperation
• affects relationship between parent and a
  spun-off unit
• may maintain long-term informal association
• affects capacity to sell outside the vertically
  integrated unit
• internal division does not usually have this
  expertise the external market is a distraction
• an acquired supplier does have this expertise it
  had marketing capacity prior to acquisition

29
Alternatives to Vertical Integration

• Tapered integration (making some and buying the
  rest)
• Joint ventures and strategic alliances
• Long term collaborative relationships
• Implicit contracts between firms

30
Tapered Integration

• A firm may produce part of its input on its own
  and purchase the rest
• A firm may sell part of its output through
  in-house sales efforts and sell the rest through
  independent distributors

31
Tapered Integration Advantages

• Additional input/output channels without massive
  capital investments
• Information about costs and profitability from
  internal operations can help in negotiating with
  market firms (threat of self manufacture can
  discipline external channels) and external
  supplier can be a yardstick to control internal
  division.
• Internal supply capabilities will protect against
  potential holdups

32
Tapered Integration Disadvantages

• Possible loss of economies of scale
• Coordination may become more difficult since the
  two production units must agree on product
  specifications and delivery times
• Managers may be self-serving in continuing with
  internal production well after it has become
  inefficient to do so

33
Tapered Integration in Gasoline Retailing

• Major oil refiners sell through their own service
  stations and through independently owned stations
• As gas stations have moved away from auto repair
  and maintenance services, the proportion of
  company owned stations are growing

34
Strategic Alliances and Joint Ventures

• Alliances involve cooperation, coordination and
  information sharing for a joint project while the
  participating firms continue to be independent
• A joint venture is an alliance where a new
  independent organization is created and jointly
  owned by the promoting firms

35
Strategic Alliance

• Alliances and joint ventures are intermediate
  solutions, between market exchange and vertical
  integration
• Rather than rely on contracts, an alliance relies
  on trust and reciprocity
• Disputes are rarely litigated but resolves
  through negotiation

36
Strategic Alliance Advantages

• Transactions that are natural candidates for
  alliances have compelling reasons to both make
  and buy
• Uncertainty surrounding future activities
  prevents the parties from going into the
  specifics of those decisions in a contract
• Transactions are complex and one cannot count on
  contract law to fill the gaps
• Existence of relationship-specific assets and
  potential holdup problem

37
Strategic Alliance - Advantages

• Any one party does not have the expertise to
  organize the transaction internally
• Market opportunity that induced the transaction
  is not expected to last very long making a long
  term contract or merger unattractive
• Regulatory environment necessitates acquiring a
  local partner for the venture

38
Strategic Alliance - Costs

• There are drawbacks
• risk of leakage of information and loss of
  control of proprietary information
• the alliance usually requires extensive
  information sharing between independent firms
• efficient coordination may be difficult to
  achieve
• no formal mechanism for resolving disputes
• suffers from agency and influence costs
• effort split across independent firms
• potential free-rider problem neither party has
  the incentive to monitor effectively because they
  not not keep all the benefits

39
Collaborative Relationships

• Japanese industrial firms appear to be smaller
  and less vertically integrated compared to their
  western counterparts
• Japanese firms organize the vertical chain using
  long term collaborative relationship among firms
  rather than arms length transactions

40
Collaborative Relationships

• Two major types of collaborative relationships
  are found in Japan
• Subcontractor networks
• Keiretsu

41
Subcontractor Networks

• Japanese manufacturers maintain close, informal,
  long term relationship with their network of
  subcontractors
• The typical relationship between a manufacturer
  and a subcontractor involves far more asset
  specificity in Japan than in the West
• Example, UK vs Japan in electronics
• short-term, narrowly defined
• mediated by contractual rather than informal
  arrangements

42
Keiretsu

• Member firms of a keiretsu hold each others
  equity
• Links among firms are further strengthened by
  personal relationships among top executives
• Most of the key activities in the vertical chain
  are performed by members of the keiretsu with
  easy coordination and no chance for holdups

43
Keiretsu
Formal, institutionalized relationship with
complex linkages
Other financial institutions
Life insurance companies
Banks
Loans
Trading Companies
Manufg Companies
Equity holdings
Trade
Satellite Companies
44
Implicit Contracts

• Implicit contracts are unstated understanding
  between firms in a business relationship
• Longstanding relationship between firms can make
  them behave cooperatively towards each other
  without any formal contracts

45
Implicit Contracts

• The threat of losing future business (and the
  future stream of profits) is enough to deter
  opportunistic behavior in any one period
• The desire to protect ones reputation in the
  market place can be another mechanism that makes
  implicit contracts viable

46
An illustration
Should commitment be reduced?
Upstream Supplier
Downstream Firm
Final Consumers
Stick with the implicit contract so long as r lt
50
Profit p.a. 1 million
Profit p.a. 1 million
Both parties have alternative trading partners
with profits of 900,000 p.a. if forced to switch
Gain one-off increase of 200,000
Both parties can increase profits to 1.2 million
by reducing commitment to the relationship
Loss long-term loss of 100,000 from collapse of
relationship
Present value of loss 100,000/r