Instructor’s Manual to accompany Economics of Strategy, Sixth Edition
CHAPTER 4: Integration and its Alternatives
CHAPTER OUTLINE
1) Introduction
2) What Does It Mean To Be Integrated?
 The Property Rights Theory of the Firm
 Alternative Forms of Organizing Transactions
Example 4.1: Vertical Integration in a Mountain Paradise
 Governance
 Delegation
 Path Dependence
 Technical Efficiency versus Agency Efficiency
 The Technical Efficiency/Agency Efficiency Tradeoff
Example 4.2: Gone in a Heartbeat: The Allegheny Health Education and Research Foundation
Bankruptcy
 Real World Evidence
 Double Marginalization: A Final Integration Consideration
Example 4.3: Vertical Integration of the Sales Force in the Insurance Industry
3) Alternatives to Vertical Integration
 Tapered Integration: Make and Buy
Example 4.4: Franchise Heat in China
 Strategic Alliances and Joint Ventures
Example 4.5: Toys “R” Us Enters Japan
 Implicit Contracts and Long-Term Relationships
Example 4.6: Interfirm Business Networks: The Downsides of Keiretsu
 Business Groups
5) Chapter Summary
6) Questions
7) Endnotes
CHAPTER SUMMARY
This chapter examines why vertical integration differs across industries, across firms within the same
industry, and across different transactions within the same firm. The first part of this chapter assesses the
Property Rights Theory (PRT). It then presents evidence on vertical integration from studies of a number
of specific industries including automobiles, aerospace, electric utilities, and electronic components
industry.
The next section examines whether there might be other factors apart from those discussed in Chapter 3
Copyright © 2013 John Wiley & Sons, Inc.
Instructor’s Manual
Economics of Strategy, Sixth Edition
that might drive a firm’s decision to vertically integrate. This section focuses on governance and
technological efficiency in vertical integration. It outlines the concept of “path dependence” and the
tradeoff between technological efficiency and agency efficiency.
The final purpose of this chapter is to explore other ways of organizing exchange besides arm’s-length
market contracting and vertical integration. The alternatives discussed include 1) tapered integration (i.e.,
making and buying), 2) joint ventures and strategic alliances, 3) Japanese keiretsu, and 4) implicit
contracts supported by reputational considerations.
APPROACHES TO TEACHING THIS CHAPTER
Overview
This chapter covers different segments, which can be taught separately. The first section covers the
concept of the Property Rights Theory (PRT) of the firm. The central idea is brought from chapter 3
where incomplete contracts alter the bargaining power between parties in vertical relationships because of
asset ownership.
At the end of this section real-world firms are examined to see if they behave according to this theory;
much evidence suggests that they do.
The next section addresses the ideas of governance, delegation and path dependency. The
technological/agency trade-off is explored in light of governance. Students should be encouraged to
discuss agency issues as they relate to integration and governance.
Technical vs. Agency Efficiency
The relationship between Technical and Agency efficiency is one of the main themes of this chapter.
Figure 6.1 illustrates the trade-off between technical and agency efficiency and is related to the discussion
in Chapter 5 about the benefits and costs of using the market. Agency vs. trade-off concepts should be
explained by means of graphs because MBA students find these concepts difficult.
∆T = cost of producing the activity in-house – cost of producing the activity by a market specialist,
assuming that both produce as efficiently as possible.
“Transactions” cost when activity is performed by a market specialist is defined broadly to include:




direct costs of negotiating contracts costs of safeguards against hold-up
costs of safeguards against hold-up.
inefficiencies due to under-investment in relationship-specific assets and lost opportunities for cost
savings due to mistrust.
costs associated with breakdowns in coordination and synchronization when activity is purchased.
∆A = “transactions” cost when activity is produced in-house – “transactions” cost when activity is
provided by a market specialist.
6-2
Copyright © 2013 John Wiley & Sons, Inc.
Economics of Strategy, Sixth Edition
Instructor’s Manual
"Transactions” cost when activity is produced in-house include:

agency and influence costs that arise when hard-edged market incentives are replaced by soft-edged
incentives of internal organization.
∆C = ∆T + ∆A = the full cost difference between vertical integration and reliance on market specialist.
When ∆ C is positive, in-house production is more costly than reliance on market specialists; when ∆ C is
negative, in-house production is less costly than reliance on market specialists.
The last section discusses alternatives to vertical integration and arm’s-length market exchange. It
introduces four alternatives, namely tapered integration, joint ventures, the Japanese keiretsu and longterm implicit contracts. The main point is that some economic trade-offs are useful in thinking about
decisions and desirability of these organizations.
Alternatives to Vertical Integration
1. Tapered Integration: Flexibility to grow without big capital outlays, gaining of valuable cost
information to help in negotiation with market firms and protection against holdup problems
2. Strategic Alliances and Joint Ventures: Ideal for situations where contracting difficult to write and
investment in relationship-specific assets need to be made by both parties. Alliances work when it is
too costly for one party to develop the necessary expertise. When the opportunity is transitory
alliances are better than outright mergers. Sometimes government regulation can require alliances
rather than a unitary firm (e.g., foreign firms required to partner with domestic firms).
3. Collaborative Relationships: Sub-contractor networks, chaebols, and keiretsus. Long-term
relationships and implicit contracts make for cooperation among firms.
DEFINITIONS
Agency Efficiency: The extent to which a firm’s administration and/or production costs are raised due to
transaction and coordination costs of arm’s-length market exchanges or agency and influence costs of
internal organization.
Implicit Contract: Unstated understanding between parties in a business relationship.
Joint Venture: A particular type of strategic alliance where two or more firms create and jointly own a
new independent organization.
Keiretsu: Close semiformal relationships among buyers and suppliers, best embodied by the Japanese.
Strategic Alliance: Two or more firms agree to collaborate on a project or to share information or
productive resources.
Technical Efficiency: The extent to which a firm uses least-cost production techniques.
Copyright © 2013 John Wiley & Sons, Inc.
6-3
Instructor’s Manual
Economics of Strategy, Sixth Edition
Tapered Integration: A combination of vertical integration and market exchanges. Under this process, the
firm makes some quantity of the input internally and buys the rest from independent firms.
SUGGESTED HARVARD CASE STUDIES
Hudepohl Brewing Company (HBS 9-381-092). Hudepohl is a private company. Presents the problem of
how an established regional brewer can survive the onslaught of national breweries, some of which are
being cross-subsidized by diversified parent companies. Requires detailed analysis of what operations are
profitable and unprofitable for Hudepohl, in addition to industry and competitive analysis. This case can
be taught with some combination of the following chapters: 2, 9, 15, and 16. You may want to ask
students to think of the following questions in preparation for the case:
a) How well is H doing? Is Bob Pohl’s optimism about H’s future justified?
b) How have the fundamental economics of the beer business changed over the 20–30 years prior to the
time of the case? Have these changes helped or hurt H?
c) What are the markets that H competes in? Which are H’s strongest markets? Which are its most
profitable markets?
d) How efficient are H’s manufacturing and distribution facilities in comparison with other beer
companies? Which activities need to be changed or dropped?
e) What are H’s strengths? What resources or assets does H have that its competitors do not have?
Does Pohl’s strategy exploit H’s resources, capabilities, and competitive advantages?
f) What alternative strategies might Pohl adapt? More generally, how would you recommend that H
position itself in the beer market, given H’s resources and assets and given the strategies of its rivals
in the beer industry?
g) Profit Analysis by Segment: Calculate or estimate H’s production costs and profit margins for each
of its four “product lines” shown in Table B: (1) draft beer sold to independent distributors, (2) draft
beer distributed by H, (3) packaged beer sold to independent distributors, and (4) packaged beer
distributed by H.
h) Value Added: Using the above profit calculations, calculate the value added at each stage of H’s
vertical chain. Can you explain the differences in the profitability across these product lines?
i) Segment Analysis: To the extent possible, calculate H’s market share in each of its market segments.
(What are the criteria you are using to distinguish H’s different market segments?)
Pepsi-Cola Beverages (HBS Case 9-390-034 A). Responding to changes in Pepsi-Cola’s competitive
environment, Roger Enrico, President and CEO of PepsiCo Worldwide Beverages, formed a task force to
investigate a possible reorganization of Pepsi’s domestic soft drink business. The task force recommends
reorganizing along geographic lines. The group has put forth two options: 1) full decentralization or 2) a
matrix organization. Ask students to analyze the options and make their own proposals for carrying out a
re-organization. They should also be asked to consider other options to deal with Pepsi’s problems that
don’t center on reorganization. This case can be assigned with some combination of Chapters 5, 9, 10,
11, 14, 15, 16, 17, and 18.
You may want to ask students to think of the following thought questions in preparation for the case:
6-4
Copyright © 2013 John Wiley & Sons, Inc.
Economics of Strategy, Sixth Edition
Instructor’s Manual
a) Perform a five-forces analysis on the soft drink industry. What is your qualitative assessment of this
industry?
b) Why are concentrate producers like Coke and Pepsi so profitable?
c) Why do concentrate producers have an incentive to buy bottlers?
d) Why are bottlers given the right to bottler Coke or Pepsi in perpetuity?
Philips Compact Disc Introduction (HBS 9-792-035). Presents the perspective of Philips in 1979, after
technical development of the CD was complete, but three years before it was introduced commercially.
At that time, Philips’ management had to decide whether to attempt to establish a CD standard through an
alliance with another consumer electronics firm. This case raises questions regarding the costs and
benefits of standardization, optimal pricing of CD players and discs (given their complementarity),
optimal pricing of a durable good, and the effects of proprietary information on entry strategies. Also
requires analysis of several related industries, with special attention to opportunities to invest in product
specific capital. This case can be assigned with some combination of Chapters 5, 11, and 16. You may
want to ask students to think of the following questions in preparation for the case:
a) What are the cost and benefits to Philips in having its standard accepted as the industry-wide format
(in the hardware)? How does the degree of Philips vertical integration affect its incentives in the
development of the hardware? How does its vertical integration affect its chances of having its
standard being adapted? How does its vertical integration effect how profitable Philips will be in the
hardware?
b) How does Philips ownership in a record company effect its position in the market for hardware?
c) Will hardware manufacturers be able to successfully engage in product differentiation? What factors
affect your answer?
d) Under what conditions should Philips build extensive disc pressing capacity in the U.S. and under
what condition should Philips wait one year?
Tombow Pencil Co. Ltd. (HBS 9-692-011). This case illustrates how another firm (in another country)
struggles with a similar make-or-buy problem. While the most prominent issues in the case are the
“boundaries of the firm” questions, the case also raises issues related to product market competition and
the role of product variety, marketing channels, and organizational issues involving the coordination of
marketing, sales, and production inside Tombow. The case also presents the differences between Keiretsu
(networks of long-term relationships) and arms-length market contracting. It introduces students to the
idea that assignment of ownership rights can solve problems that arise due to physical asset specificity
(hold-up, human asset specificity). As with Nucleon (see Chapter 5), it shows that there are strong
relationships between production strategy, product market strategy, and the make-or-buy decision. This
case can be taught with some combination of the following chapters: 5, 13, 14, 16, and 17. You may
want to ask students to think of the following questions in preparation for the case:
a) What is Tombow Pencil’s current financial position? Look at Tombow’s financial statement, and
compare their financial ratios to Mitsubishi’s. In particular what would the impact be on Tombow’s
profits if they could reduce their inventory/sales ratio to Mitsubishi’s level?
b) Is the Japanese pencil industry profitable? Are there some segments that are more profitable than
others?
Copyright © 2013 John Wiley & Sons, Inc.
6-5
Instructor’s Manual
Economics of Strategy, Sixth Edition
c) Compare the vertical chains for wooden pencils and the Object EO pencil (which will be our
metaphor for mechanical pencils in general). Are the differences in the vertical scope/vertical
boundaries in these two chains consistent with the underlying economics of make or buy decisions?
Why does Ogawa feel the need to reexamine the production system for the EO pencil, given that
Tombow’s vertical relationship have served them well for so long?
d) What recommendations would you make for Tombow? Consider both the market position (product
line, quality, price point, etc.) the horizontal and vertical scope, and the organization of the company.
EXTRA READINGS
The sources below provide additional resources concerning the theories and examples of the chapter.
Anderson, E., and D. C. Schmittlein, “Integration of Sales Force: An Empirical Examination,” RAND
Journal of Economics, 15, 1984, pp. 385–395.
Arrow, K., “Vertical Integration and Communication,” Bell Journal of Economics, 6, 1975, pp. 173–182.
Borenstein, S., and R. Gilbert, “Uncle Sam at the Gas Pump: Causes and Consequences of Regulating
Gasoline Distribution,” Regulation, 1993, pp. 63–75.
Caves, R., and D. Barton, Efficiency in US Manufacturing Industries, Cambridge: MIT Press, 1990.
Chandler, A. D., Jr., Scale and Scope: the Dynamics of Industrial Capitalism, Cambridge, MA, Belknap,
1990.
Clark, R., The Japanese Company, New Haven: Yale University, 1979.
Davidow, W. H., and M. S. Malone, The Virtual Corporation, New York: Harper Business, 1992.
Grossman, S., and O. Hart, “The Costs and Benefits of Ownership: A Theory of Vertical and Lateral
Integration,” Journal of Political Economy, 94, 1986, pp. 691–719.
Joskow, P., “Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric
Generating Plants,” Journal of Law, Economics and Organization, 33, 1985, pp. 32–80.
Klein, B., “Vertical Integration as Organizational Ownership,” Journal of Law, Economics, and
Organization, 1989, pp. 199–213.<Author Query>Please add volume number</Author Query>
Machlup, F., and M. Taber, “Bilateral Monopoly, Successive Monopoly, and Vertical Integration,”
Economist, 27, 1950, pp. 101–119.
Masten, S., “The Organization of Production: Evidence from the Aerospace Industry,” Journal of Law
and Economics, 27, 1984, pp. 403–417.
Masten, S., J. W. Meehan, and E. A. Snyder, “Vertical Integration in the U.S. Auto Industry: A Note on
the Influence of Transactions Specific Assets,” Journal of Economic Behavior and Organization, 12,
1989, pp. 265–273.
McKenzie L.W., “Ideal Output and the Interdependence of Firms,” Economic Journal, 61, 1951, pp. 785–
803.
Monteverde, K., and D. Teece, “Supplier Switching Costs and Vertical Integration in the Automobile
Industry,” Bell Journal of Economics, 13, 1982, pp. 206–213.
Ohmae, K., “The Global Logic of Strategic Alliances,” Harvard Business Review, March–April 1989, pp.
143–154.
Perry, M. K., “Forward Integration by Alcoa: 1888–1930,” Journal of Industrial Economics, 29, 1980,
pp. 37–53.
6-6
Copyright © 2013 John Wiley & Sons, Inc.
Economics of Strategy, Sixth Edition
Instructor’s Manual
Perry, M., “Price Discrimination by Forward Integration", Bell Journal of Economics, 9, 1978, pp. 209–
217.
Peters, T., Liberation Management. Necessary Disorganization for the Nanosecond Nineties, New York,
Knopf, 1992.
Spengler, J. J., “Vertical Integration and Antitrust Policy,” Journal of Political Economy, 53, 1950, pp.
347–352.
Wallace, D. H., Market Control in the Aluminum Industry, Cambridge, MA, Harvard University Press,
1937.
Williamson, O. E., Antitrust Economics, Oxford, UK, Basil Blackwell, 1987, chaps. 1 through 4, for a
discussion of the role of transactions cost considerations in antitrust policy.
Williamson, O., “Strategizing, Economizing and Economic Organization,” Strategic Management
Journal, 12, 1991, pp. 75–94.
SUGGESTED ANSWERS TO END-OF-CHAPTER QUESTIONS
1. What is the property rights theory of the firm? Is this theory consistent with the theories of
vertical integration described in Chapter 3?
The property rights theory (PRT) of the firm states that integration determines the ownership and
control of assets and it is through ownership and control that firms are able to exploit contractual
incompleteness. Integration matters because it determines who gets to control resources, make
decisions, and allocate profits when contracts are incomplete and trading partners disagree.
The PRT is consistent with the theories of vertical integration described in chapter 3. PRT controls
the resolution of the make-or-buy decision and that outcome is dependent on which firm controls
assets and the right to disburse revenues from those assets. Because contracts are incomplete, vertical
integration occurs in accordance with the PRT so firms can control the relationship specific assets.
2. Use property rights theory to explain why stockbrokers are permitted to keep their client lists
(i.e., continue to contact and do business with clients) if they are dismissed from their jobs and
find employment at another brokerage house.
The time required to develop of client lists is the key investment in the sales portion of stock
brokerage. According to PRT, the integration decision should turn on the relative of importance in
developing persistent clients by stock brokers versus list-building activities by the brokerage house.
Clients are loyal to their broker because they deal with, and trust, their judgment, while they have
little or no loyalty to the brokerage house who they view merely as the “order taker” that execute their
invest trades. The investment (ownership) of client lists, therefore, needs to be made by the stock
broker not the firm.
A brokerage firm’s assets are tied to each of its clients, and clients are the largest source of total
profits of the firm. The nature of the relationship between a stockbroker and client is relationshipspecific. The broker has ownership of each of his/her clients. The broker is investing the time and
information into developing these relationships. Therefore, the broker has the ownership of those
assets. Accordingly, the broker has residual rights to the ownership and control of clients. When
Copyright © 2013 John Wiley & Sons, Inc.
6-7
Instructor’s Manual
Economics of Strategy, Sixth Edition
ownership of the broker changes, the broker’s relationship-specific assets, the selling party, the
original brokerage firm, loses the clients. While ownership of specialized physical assets can be
transferred, ownership of specialized human capital can’t be. The brokerage house simply provides
products. It is the broker who sources and services their clientele.
The nature of the product (stock trades) dictates that brokerage houses allow the stock
brokers to keep client lists. Customers often have an incentive to switch their brokerage
business to obtain better value for money. This is particularly true for clients doing high
volume of trades. In these circumstances it becomes important for the broker to generate
extra effort to keep the client. If the broker has the ownership of the asset (client list), he is
not subject to holdup by the brokerage house. If he did not own the client list, the brokerage
house could force the broker to accept lower commissions. This would reduce the incentive
for the broker to try hard to generate business for the brokerage house.
3. “Integrated firms are more efficient than independent firms if the central office is more
efficient than the courts.” Explain this statement. To what extent do you agree?
The production of a good or service by a firm can either have some or all of its processes
made or bought. If the firm is able to exercise strong governance and internal controls over
its integrated processes, its costs from agency and coordination effects will be minimal.
Comparatively, if the firm does not have an efficient central control system over its
processes, then its productions costs will be high. Purchasing upstream and downstream
processes can offset the high costs of central office efficiency and administration, but only to
the extent the contracts for those processes are near complete. Incomplete contracts can
result in litigation which increases the cost of buying versus making production.
This quote implies that all, or most, contracts are incomplete to the extent they will end in
litigation. Likewise it assumes the cost of that litigation will exceed the expense of strong
central office controls. Most contracts do not end in litigation and therefore the cost of
buying versus making is most likely skewed towards buying.
4.
How is your ownership of Economics of Strategy path dependent? To what extent does this
path dependency provide you with a unique opportunity to exploit what you learned from this
book?
The ownership of the book allows me to exploit its information. Since I own the book, I possess the
value of the information it contains. Were I to merely have rented the book, I would lose the ability
to utilize the knowledge it contains (assuming I need to refer to it) once the rental period expired. I
can exploit this ownership by selling my access to the book and the knowledge it contains.
Essentially, I can “rent” the knowledge for a revenue stream to individuals who either need
information from the book, or the opportunity to use the book itself.
5. Why is the “technical efficiency” line in Figure 4.1 above the x-axis? Why does the “agency
efficiency” line cross the x-axis?
6-8
Copyright © 2013 John Wiley & Sons, Inc.
Economics of Strategy, Sixth Edition
Instructor’s Manual
The technical efficiency line represents the minimum cost of production under vertical integration
minus the minimum cost of production under arm’s-length market exchange. The technical
efficiency line is above the x-axis indicating that the minimum cost of production under vertical
integration is higher than the minimum cost of production under arm’s-length market exchange,
irrespective of the level of asset specificity. The reason costs are higher under internal organization is
that outside suppliers can aggregate demands from other buyers and thus can take better advantage of
economies of scale and scope to lower production costs.
The agency efficiency line represents the transactions costs when production is vertically integrated
minus the transactions costs when it is organized through an arm’s-length market exchange. The
agency efficiency line is positive for low levels of asset specificity and negative for high levels of
asset specificity. When asset specificity is low, the probability of hold up is low. In the absence of a
significant risk of hold up, market exchange is likely to be more agency efficient than vertical
integration because independent firms often face stronger incentives to innovate and to control
production costs than divisions of vertically integrated firms (see Chapter 5). Agency costs of market
exchange increase with the level of asset specificity—above some threshold of asset specificity, using
the market entails higher transactions costs than using an internal organization.
6. Why is the “technical efficiency” line in Figure 6.1 above the x-axis? Why does the “agency
efficiency” line cross the x-axis?
The technical efficiency line represents the minimum cost of production under vertical integration
minus the minimum cost of production under arm’s-length market exchange. The technical
efficiency line is above the x-axis indicating that the minimum cost of production under vertical
integration is higher than the minimum cost of production under arm’s-length market exchange,
irrespective of the level of asset specificity. The reason costs are higher under internal organization is
that outside suppliers can aggregate demands from other buyers and thus can take better advantage of
economies of scale and scope to lower production costs.
The agency efficiency line represents the transactions costs when production is vertically integrated
minus the transactions costs when it is organized through an arm’s-length market exchange. The
agency efficiency line is positive for low levels of asset specificity and negative for high levels of
asset specificity. When asset specificity is low, the probability of hold up is low. In the absence of a
significant risk of hold up, market exchange is likely to be more agency efficient than vertical
integration because independent firms often face stronger incentives to innovate and to control
production costs than divisions of vertically integrated firms (see Chapter 5). Agency costs of market
exchange increase with the level of asset specificity—above some threshold of asset specificity, using
the market entails higher transactions costs than using an internal organization.
7. How might globalization and advances in information technology affect the tradeoffs
between technical and agency efficiency?
Globalization and advances in information technology reduce agency costs and increase the
incentive to buy rather than make processes. Technical efficiency possessed by the firm
becomes less valuable when specialized processes can be more easily and reliably bought.
Additionally, the reduction in agency costs increases the likelihood that the contracting firm
Copyright © 2013 John Wiley & Sons, Inc.
6-9
Instructor’s Manual
Economics of Strategy, Sixth Edition
can realize economies of scale further reducing total production costs beyond those that were
obtained with vertically integrated technical efficiency. Globalizations and advances in
information technology “tip” the tradeoff between technical and agency efficiency towards
agency efficiency.
8. Is the following statement correct? “Double marginalization helps firms because it
enables them to raise prices.”
No. Double marginalization is the issues that arise when an input supplier with market
power exploits that power by selling above its marginal costs to a manufacturer with market
power that similarly sells the finished product above its marginal costs. This “double
counting” results in the final product price being higher than the optimal market price to
maximize profits. While a firm may raise its price to compensate for the economic profit of
the supplier firm, the sum of profits earned by both firms will be less than their combined
maximized profit because a lesser quantity will be sold in the market resulting in a loss of
total revenue.
9. Analysts often array strategic alliances and joint ventures on a continuum that begins with
“using the market” and ends with “full integration”. Do you agree that these fall along a
natural continuum?
No. Alliances and joint ventures fall somewhere between arm’s-length market transactions and full
vertical integration. As in arm’s-length market transactions, the parties to the alliance remain
independent business organizations. But a strategic alliance involves much more coordination,
cooperation, and information sharing than an arm’s-length transaction. A joint venture is a particular
type of strategic alliance in which two or more firms create, and jointly own, a new independent
organization. The firms involved with a joint venture integrate a subset of their firm’s assets with the
assets of one or more other firms
10. How are franchising and tapered integration similar? How do these strategies differ?
Franchising and tapered integration are similar in that franchising allows a firm to utilize
downstream suppliers to sell, distribute and deliver their products, while tapered integration
allows firms to likewise downstream apportion of their products through other firms. An
example would be McDonalds which owns several stores itself and is the final provider of
sales, products and service to customers, yet it also franchises locations and those owner
firms become the final provider of the goods and services. Both cases are similar in that
McDonalds receives revenue from its franchisees as well as from its integrated direct tapered
sales – and likewise in both cases, customers receive the same Big Macs and French fries.
These strategies differ because in the franchise case, the firm licenses it products and relies
on the completeness of its contracts to maximize revenue and profits. In tapered integration,
the firm is in control of a portion of its production and sales and it does not rely on
contracting to maximize revenue and profits, but rather its ability to manage its technical
6-10
Copyright © 2013 John Wiley & Sons, Inc.
Economics of Strategy, Sixth Edition
Instructor’s Manual
costs.
11. Most people rely on implicit costs in their everyday lives. Can you give some
examples? What alternatives did you have to achieve the desire outcome?
An example would be the division of labor within a household where two roommates share
the kitchen responsibilities with an implicit contract whereby one person prepares the meals
and the other person cleans the dishes afterwards. This informal (implicit) arrangement
works because each party knows if they do not do their part, the other party will likewise
renege and both will suffer higher implicit costs individually and collectively. An alternative
to this implicit arrangement would be to have both roommates contribute money to a fund
and jointly hire a cook to prepare their meals and clean the kitchen. Likewise, the roommates
could pay each other for their service of cooking and cleaning.
Another example would be table service in a restaurant. The implicit cost of good service is
the expectation the server will receive a tip at the end of the meal. This is not a contract, and
certainly not enforceable in court, but the implicit contract between the diner and the server is
honored because both parties are compensated for their effort. The diner receives good
service in return for a paying a fee (the tip) and the server receives revenue (the tip) in return
for providing good service. The desired outcome could alternatively be achieved by initially
paying ahigher wage to the server and charging a higher menu price for the food. This higher
salary would incent the server to provide good service or lose a high paying job, and the
diner would willingly pay the higher menu prices if not tip was required.
12. Suppose you observed a hostile takeover and that the aftermath of the deal included
plant closings, layoffs, and reduced compensation for some remaining workers in the
acquired firm. What would you need to know about this acquisition to determine
whether it would be best characterized by value creation or value redistribution?
The level of vertical integration in the merged firms would provide key insight into whether
the acquisition was characterized by value creation or value redistribution. If the plant
closings and layoffs were of processes already owned by the acquiring firm, then value
redistribution would be the primary objective of the acquisition. However, if the plant
closings and layoffs were due to increased central office efficiency then value creation would
be the motivating factor. Essentially, the key question would be to ask whether the layoffs
and closings were of duplicative processes, or due to efficiencies gained from vertical
integration.
Copyright © 2013 John Wiley & Sons, Inc.
6-11
Instructor’s Manual
Economics of Strategy, Sixth Edition
13. What does the keiretsu system have in common with traditional strategic alliances and joint
ventures? What are some of the differences?
Keiretsu are closely related to subcontractor networks, but they involve a somewhat more formalized
set of institutional linkages. Usually the key elements of the vertical chain are represented in a
keiretsu. The firms in a keiretsu exchange equity shares, and place individuals on each other’s boards
of directors—U.S. firms are in many cases prohibited from these practices under the U.S. antitrust
laws.
14. How are business groups like Tata similar to traditional diversified firms like
General Electric? How are they different?
Business groups like Tata are similar to traditional diversified firms in that they typically
maintain a uniform code of conduct and governance across their diverse business groups.
Diversified firms such as General Electric maintain strong corporate control over their
divisions, yet allow independent management of product specific issues. Buisiness grouips
like Tata do the same, exercising group culture and value propositions while allowing the
individual businesses to independently manage their products and markets.
Goups like Tat differ from traditional diversified firms because they do not own all of the
individual assets, but rather, they rely on contracts to achieve vertical integration. Firms like
General Electric may purchase upstream or downstream processes, but within their technical
expertise they own and control those assets. Groups like Tata depend on informal contracts
and relationships to achieve vertical integration of possessed technical expertise.
15. The following is an excerpt from an actual strategic plan (company and product names have
been changed to protect the innocent):
Acme’s primary raw material is PVC sheet that is produced by three major vendors within the United
States. Acme, a small consumer products manufacturer, is consolidating down to a single vendor.
Continued growth by this vendor assures Acme that it will be able to meet its needs in the future.
Assume that Acme's chosen vendor will grow as forecast. Offer a scenario to Acme
management that might convince them that they should rethink their decision to rely on a
single vendor. What do you recommend that Acme do to minimize the risk(s) that you have
identified? Are there any drawbacks with your recommendation?
Acme must have a valid reason for using a single supplier. A key merit of Acme's approach is asset
specificity on the vendor's side, when the vendor might be encouraged to make specific investments.
However, there is the potential of hold-up problems created by decreasing the number of vendors
down from three to one. The likelihood of holdup problems would depend on the degree of asset
specificity and switching costs. The amount of implicit and explicit costs related to hold-up problems
would depend on the level of inventory, customers' expectations and brand reputation. For example,
if Acme can only produce its product with Company X's component and Company X ceases
shipments, unless Acme has sufficient amount in inventory of the components, Acme will incur
significant losses immediately due to lack of sales.
6-12
Copyright © 2013 John Wiley & Sons, Inc.
Economics of Strategy, Sixth Edition
Instructor’s Manual
In order to minimize its risks, Acme could second source or backward integrate (partially or fully).
Second sourcing or backward integration protects the firm from holdup but may drive costs by
reducing purchasing discounts, increasing production coordination and requiring additional
investments by the second source. An alternative solution would be for Acme to consider tapered
integration. Tapered integration poses the usual make-or-buy problems, such as high costs,
coordination problems, and poor incentives.
Copyright © 2013 John Wiley & Sons, Inc.
6-13