Unit 1
Microeconomics of the Firm
Vertical Integration
AEC 422
Lecture 4
See Besanko Ch 5
Vertical Chain
Begins with the acquisition of raw
materials
Ends with the sale of finished
goods/services
Can include support services such as
Finance and Marketing
Organizing the vertical chain is an
important part of business strategy
Channel management
Organization of the Business
Firm Infrastructure
Support
activities
Human Resource Management
Technology Development
Procurement
Porter’s Organization of the Firm
Margin
& Sales
Primary
activities
Marketing
Profit
Supply Chain Management
 “upstream” suppliers provide
many kinds of resources to
operate the firm.
 Most firms have many types of
suppliers
 Scope of activities within a firm
can be many
 Production, research,
packaging, distribution
Key Supplier or Partner
YOUR FIRM
 Many small firms choose
to outsource to secure
use of certain assets
made available in the
market by other firms
 Advertising
 Tax management
 Distribution
 Web management
Key Customer
Supply Chain Management
 “upstream” suppliers provide
many kinds of resources to
operate the firm.
 Scope of activities within a firm
can be many
 Production, research,
packaging, distribution
Key Supplier or Partner
 Many small firms choose
to outsource to secure
use of certain assets
made available in the
market by other firms
 Advertising
 Tax management
 Distribution
 Web management
YOUR FIRM
Key Customer
Outsourcing and integrating
 UPS Supply Chain Solutions

Papa Johns
Foodservice, Inc.
 Accountemps - Accounting Staffing Agency
 Vineyard – winery
 Web design
 Q-Labs microbial testing
Upstream
Firm
Downstream
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 outsourced?
 Choice between the “invisible hand” of the
market and the “visible hand” of the organization
(Make or Buy)
 Like criteria for scope economies – which
system is cheaper?
 Some creative uses of outsourcing –
implications for the balance sheet
Make or Buy Continuum
Arm’s length Market Transactions
Less Integrated
Long-Term Contracts
Strategic Alliances/Joint Ventures
Vertical Coord.
Parent/Subsidiary Relationship
More Integrated
Perform Activity Internally
Do we make it ourselves or buy it?
 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)
Do we make it ourselves or buy it?
Other factors
Frequency and volume of purchase/need
Uniqueness of the asset
Proprietary nature of the product
Also relates to the merger & acquisition
issue
Sometimes the best strategy is to pursue
vertical integration
Grape Sourcing by MidSouth Wineries
% Grown in % contracted % purchased
own
with other
on spot
vineyards
growers
market
Small (<3000
cases)
Large (3000 or
more cases)
64.1
29.0
6.2
45.4
41.5
11.9
Source: 2011 Winery Price and Market Survey
Elk Creek Winery, KY
Benefits and Costs of Using the Market
BENEFITS: - can be cheaper
Market Firms Can Achieve Economies of Scale:
In-House Production May Be Too Low
Market Firms Must Be Efficient to Survive In The Market
Environment
COSTS: - may be hidden costs
Coordination May Be Compromised
Private Information May Be Leaked
There May Be High Transaction Costs In The Market
ie, search, paperwork, post-purchase recourse
Benefits of Using the Market
 Market firms (outside specialists) may have
patents/proprietary information that makes low cost
production possible
 Market firms can sometimes achieve economies that inhouse units cannot
 Market firms are subject to market discipline, whereas inhouse units may be able to hide their inefficiencies
behind overall corporate success (Agency and influence
costs)
 Often there are choices in channel partners with which to
work
Agency Costs
 Does the outside firm have the same commitment to the
delivery of the product or service needed?
Not always - conflicts of interest, other clients
 Example: Purity Foods, Inc.
 Can have internal agency costs, too – managers &
workers knowingly do not act in the best interest of the
business
Influence costs
 In addition to internal agency costs, performing a
task in-house will lead to “influence costs” as
well
 Influence cost – time consumed by a manager
campaigning central management to allocate
resources to his/her division
 Note – a poor process of external “bidding” can
add to the cost of outsourcing, as well. Need to
find the right firm the first time.
Problems in Using the Market: Lack of Control
Costs imposed by poor coordination
Reluctance of partners to 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
Candy New Product Development
Upstream
Firm
New Product Development
Stages
Downstream
Buyer
Involved
Buyer
Not
Involved
Supplier
Involved
Supplier
Not
Involved
months of development time
Concept Search
1.9
2.4
2.0
2.3
Concept Screening
2.5
0.6
1.3
0.7
Concept Testing
1.6
0.7
1.5
0.8
Business Analysis
2.9
1.7
2.2
1.8
Product Development
3.4
3.0
3.0
2.0
Product Testing
2.3
0.9
1.2
0.7
Commercialization
3.3
2.1
2.3
1.9
…..outsourcing generally adds to development time.
Source: Woods and Spaulding, J Food Distr Research 2006
Make or Buy Continuum
Arm’s length Market Transactions
Less Integrated
Long-Term Contracts
Strategic Alliances/Joint Ventures
Vertical Coord.
Parent/Subsidiary Relationship
More Integrated
Perform Activity Internally
Complete Contract
 A complete contract stipulates what each party should
do for every possible contingency
 No party can exploit others’ weaknesses
 To create a complete 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
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 nonperformance
Real life contracts are usually incomplete
contracts
Incomplete Contracts
Incomplete contracts
Involve some ambiguities
Need not anticipate all possible contingencies
Do not spell out rights and responsibilities of
parties completely
Factors that Prevent Complete
Contracting
Bounded rationality
Difficulties in specifying/measuring
performance
Asymmetric information
Bounded Rationality
Individuals have limited capacity to
Process information
Deal with complexity
Pursue rational aims
Individuals cannot foresee all possible
contingencies
Specifying/Measuring Performance
 Terms like “normal wear and tear” may have
different interpretations
 Performance cannot always be measured
unambiguously
Asymmetric Information
 Parties to the contract may not have equal
access to contract-relevant information
 One party can misrepresent information
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
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
Timing
Size
Color
Case in point: Private Label
Grocery Products
Sequence
R & D
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
Design Attributes
Design attributes are attributes that need
to relate to each other precisely; else
significant loss in economic value results
Some examples
Sequencing of courses in MBA curriculum
Fit of auto sunroof glass to aperture
Timely delivery of a critical component
Design Attributes
If coordination is critical, administration
control may replace the market
mechanism
Design attributes may be moved in-house
Pepsi-Cola and its Bottlers
Make or Buy Continuum
Arm’s length Market Transactions
Less Integrated
Long-Term Contracts
Strategic Alliances/Joint Ventures
Vertical Coord.
Parent/Subsidiary Relationship
More Integrated
Perform Activity Internally
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
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
Alliance Relationships
Transaction based
Alliance based
Short-term relationships
Multiple suppliers
Adversarial relationships
Price dominates
Minimal investment from suppliers
Long-term relationships
Fewer suppliers
Cooperative partnerships
Value-added services dominate
High investment for both buyer and
supplier
Extensive product, marketing, and
logistics information sharing
Firms are interdependent with joint
decision making
Extensive interaction between buyer
and supplier functional areas
Minimal information sharing
Firms are independent
Minimal interaction between
respective functional areas
Source: D. Ross: Competing Through Supply Chain Management, 1999
Supply Chain Management
 Integration (make or buy)
ultimately about the structure
that delivers the greatest value
 Internal vs external economies
Key Supplier or Partner
YOUR FIRM
Key Customer