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Strategic Management II
1. Vertical Boundaries of the Firm - Chapter 3 & Chapter 4
In general, goods in a production process flow along a vertical chain from raw materials and
component parts to manufacturing, distribution and retailing. The challenge here is which
part of the process should outsource (buy) and which should be integrated in the firm
The main concern is the costs associated with each of one, but have some choices to structure them.
Early steps in the vertical chain are upstream, and the later ones are downstream. Thus, a firm can: - - Backward Integration (Upstream): Moving closer to sources of raw materials by acquiring resource suppliers or manufacturing the components needed for production of final product.
Forward Integration (Downstream): Moving closer to end-user (acquire retail outlets for distribution, etc.).
Make-or-Buy Fallacies - Firms should make an asset, rather than buy it, if that asset is a source of competitive advantage for that firm. (An asset easily obtained in the market cannot be a source of advantage).
- Firms should buy, rather than make, to avoid the costs of making the product. (It doesn’t eliminate the expenses of the associated activity).
- Firms should make, rather than buy, to avoid paying a profit margin to independent firms. (If the margin is so high, then other competitors would enter the market to push prices down).
- Firms should make, rather than buy, because a vertically integrated producer will be able to avoid paying high market prices for the input during periods of peak demand 1 or scarce supply. (There is no need to vertically integrate to eliminate price fluctuations. They can enter into long term contracts).
- Firms should make, rather than buy, to tie up a distribution channel. They will gain market share at the expense of rivals.
Make better than Buy - - - How many firms are available to undertake the activities? The fewer the companies, more attractive is to make.
Is transaction-specific investment needed? If it is, make is more attractive.
Does limited information permit cheating? To make can limit opportunism.
Are taxes or regulation imposed on transactions? To make can avoid them.
Do the two stages have similar optimal scale of operation? The greater the similarity, the more attractive is to make.
Are the two stages strategically similar? The greater the similarity, the more attractive is to make.
Leakage of proprietary information: outsourcing some activities may reveal critical and valuable information known only to the firm Coordination failures: transacting in the market may lead to bottlenecks because of poor coordination (use contracts with penalties and rewards).
Transaction costs: writing market contracts is costly and time-consuming, and contracts are generally incomplete. Contingencies are difficult to foresee, and contractual violations are difficult to enforce in courts.
Asset specificity: generates quasi-rents and fosters post-contractual opportunism.
The presence of relationship-specific assets increases transactions costs, generating a lack of trust in the negotiation, renegotiations, investments to avoid opportunism, or suboptimal investment.
Double marginalization: when both firms contracting through the vertical supply chain have market power in their respective activities, price formation is suboptimal. By independently setting their prices, firms obtain lower profits than under full integration.
Buy better than Make - - - Production volume: if the size of the firm is small relative to the economies of scale, scope, or learning that are present, there is an opportunity to reduce costs by outsourcing. Extreme case: natural monopoly (high market power).
Market discipline: Suppliers facing strong competitors are going to be efficient and set competitive prices, which are cheaper than agency costs within the firm. (arise because employees incentives are not aligned with value maximization).
Scale diseconomies: bureaucracy, influence costs, and conflicts of interest.
Hold-up Problem When we are in asset-specificity and incomplete contracts, there exist a risk of postcontractual opportunism. For example: We have a can-maker planning to set near a firm red2 cola. It sell it at 0,25€/can with a cost of 0,1€/can, but could also sell it to green-cola at same price, but with a cost of 0,2€/can.
The NPV of both possible operations would be, assuming no discounting rate for simplicity: NPVred =-1000000+[(0,25-0,1)*1000000]*10= 500000€ NPVgreen =-1000000+[(0,25-0,2)*1000000]*10= - 500000€ Thus, can-maker should sign the contract with red cole (NPV>0). However, after one year red-cola may behave opportunistically and renegotiate a lower price, once the sunk cost (1000000€) is already done. Now: NPVred =-1000000+[(0,25-0,1)*1000000]*1+[(0,19-0,1)*1000000]*9= - 40000€. In this case, the NPV of building the plant is negative, but is higher than the other best option (can’t deviate, and red-cola is benefiting). Thus, can-maker fears being hold up and prefers not to invest.
The elements that rise hold-up: - Incomplete contracts: open the door to opportunistic behavior.
Relationship-specific assets: the value of the assets is lower outside the relationship, in their best alternative use.
The hold-up problem increases transaction costs (Parties will dedicate more time and effort to negotiating market contracts). In the worst case scenario, investment in assets with a high-degree of specificity will need to be integrated inside the firm.
The solution for hold-up problem is in fact integration, because of differences in the governance mechanism (disagreements solved inside-no need of courts, long-term relationships are foreseen within a firm (unlikely in market transactions).
Double Marginalization There is Firm A, producing a unit cost ca, and Firm B, producing the final product at cb. Both firms have power in their respective markets. Demand for the final product is: ( ) The optimal price of pb, given pa, is: ( ) ( ) Firm A will put its price anticipating pb: ( ) ( ) In equilibrium: 3 ( ) ( ) If they were vertically integrated ( a monopoly with unit cost ca+cb): ( ) We see clearly that . If one of the firm would not have market power (either pa=ca or pb=cb), we would obtain the monopoly solution.
Hybrid Solutions These solutions try to balance technical efficiency (which can be obtained by outsourcing processes) and agency efficiency (which is obtained internally in the firm). The objective is to minimize the sum of production and transaction costs incurred.
- - - Tapered Integration: Outsource a certain volume of production and integrate the remaining.
o Advantages: better information and incentives over the market and internal processes, flexible capacity, control of risk.
o Disadvantages: coordination problems, not exhausting economies of scale/scope.
Alliances and Joint Ventures: Two or more firms collaborate on a project, share information and/or production assets: o Advantages: Adequate for activities in which there are reasons both to outsource and to integrate. Flexible and dynamic collaboration, disagreements are solved by internal negotiation and not in court. In the joint venture, cooperation is established through a new organization of shared property. This reinforces the alignment of incentives among participants.
o Disadvantages: Disclosure of confidential information, coordination problems, misalignment of incentives Subcontractor network: Firms pertaining to the network form semi-informal long-term relationships. (Implicit contracting). The repeated nature of transactions inside the network reduces transaction costs, allowing subcontractors to execute more complex processes and facilitating the exchange of information and the investment in assets with a higher degree of specificity. (The Asian model. Japanese CaseKairetsu; Spanish Case Mercadona).
Market Power in the Vertical Chain The structure of the vertical chain of production determines the distribution of market power among firms and how much surplus is appropriated in each stage of the chain.
4 Market power can be exerted from a single stage of the vertical chain (DeBeers have a lot of market power and they were only at the beginning of upstream – monopoly of diamond mines). When there is market power in several stages, however, double marginalization provides a rationale for integration or collusion through the vertical chain.
Consider now a forward integration (Firms of stage 1 integrate firms of stage 2), which is efficient c12<c1+c2. Integration doesn’t affect the intensity of competition. A backward integration by firms of stage 2 leads to the same output.
Now consider that there is one stage with a monopoly, and the remaining ones don’t have any market power.
- - Single Monopoly Profit Principle: A single monopolist can extract full monopoly profits from the vertical chain without engaging in vertical integration or exclusion (This is a strong result, but exceptions arise when contracts exhibit externalities across the vertical chain or the monopolist cannot commit to prices).
Stage Collusion: Effective collusion by firms active in the same stage of the vertical chain allows them to jointly appropriate monopoly profits.
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