CHAPTER 9
CORPORATE
STRATEGIES
© C. Patrick Woodcock
Competitive StrategyText: Chapter 9
We would rather lose some synergy across the groups than hamper decision making and
entrepreneurialism within them.
Laurent Beaudoin, Chairman Bombardier Inc.
I think …when we started here, that didn’t have a lot of focus and didn’t have a lot of reason
for being.” “Over the last five years or so, we’ve taken the disparate parts of Weston and
concentrated them on the baking business. It’s been a matter of simultaneous rationalization
and rebuilding.
Richard Currie, Past President of Loblaws and Weston Foods Inc.
Corporate Strategy
The text has so far focused on freestanding businesses competing in a single-product
market (i.e., single competitive market position). We have examined the choices that these
businesses make in order to increase customers’ willingness to pay without incurring a
commensurate increase in opportunity cost. A given business’s choices amount to a
competitive strategy, which determines its ability to generate and capture competitive
advantage through appropriate competitive market positioning and developing strong
capabilities. Ultimately this creates profits. Large corporations, however, tend to be
composed of multiple business units competing in different markets. This chapter examines
the ability to extend competitive advantage when companies invest in businesses not sharing
the same business strategy (i.e., competitive market position and competitive capabilities).
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Corporate strategy involves the management of firms in different competitive market
positions (or market). Ownership of firms in different competitive market positions is
described as diversification. There are three types of diversification. Geographic
diversification involves having business units that focus on different geographic markets
(e.g., Asia, Europe, North America, etc.). Geographic diversification is discussed more
thoroughly in Chapter 18, Managing International Strategy, and will not be examined further
in this chapter.
Then there is horizontal and vertical diversification which describes how the companies
are related to one another from a product and market perspective. Vertical integration
describes firms that are in a supply chain relative to one and another. Normally, this means
that one firm suppliers the other (i.e., if only two firms are owned). Horizontal diversification
is when firms are in different product markets and they don’t supply one another. In general
there are two types of horizontal diversification: related and unrelated diversification. Related
diversification describes two firms that share some types of resources, capabilities, assets,
etc. This provides some synergy at the business strategy level to create competitive
advantage as will be discussed below. Unrelated diversification is where business units do
not share any resources, skills, capabilities, etc. to create competitive advantage between
businesses.
1
Corporate Strategy & Diversification
Managing Corporate Strategy under Related Horizontal & Vertical
Diversification.
Take, for example, Maple Leaf Foods, a corporation having four business units1:
agribusinesses, slaughterhouses, meat processing and gourmet food processing. The
corporation is schematically illustrated in Figure A, where the four blue ovals represent
business units owned by Maple Leaf Foods and the dotted rectangle represents the boundary
of the firm. The dotted arrows linking the business units indicate flows of outputs among
units.
Figure A Maple Leaf Food`s Multimarket Presence
Agribusinesses
(Poultry & hog farming)
Slaughterhouses
Meat
Gourmet Food
Processing
Processing
1
Maple Leaf actually has more than this many business units, but to reduce the complexity we are going to only
look at these four units.
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A multitude of corporate strategy choices can generate corporate advantage, but two are
particularly important (and readily apparent in Figure A). First, Maple Leaf Foods has
chosen to operate simultaneously in agribusinesses, slaughterhouses, meat processing and
gourmet food processing. The corporation has also chosen not to operate in other industries,
such as food retail, publishing, or food processing machinery. We use the term corporate
scope to denote the markets in which the corporation has chosen to maintain a
competitive presence. Second, Maple Leaf Foods chose to own at least one business unit to
2
To characterize a corporation like Maple Leaf Foods, we use the concept of corporate
strategy. We define corporate strategy as a set of choices that a corporation makes to create
value through configuration and coordination of its multimarket activities. Thus, corporate
strategy is different from competitive strategy, which we discussed earlier in the course.
Corporate strategy pertains to the corporation as a whole, whereas competitive strategy
pertains only to business units. Corporate strategy addresses choices about multimarket
activities, while competitive strategy is a set of choices confined to a single market. However,
there is an important point of integration between the two strategies: corporate strategy, if
well designed and executed, will feed into the competitive strategies of the business units
and will enhance their competitive advantage over and above what they could achieve
otherwise. When this occurs, the business units benefit from corporate advantage.
serve each of these markets. There are a number of alternative ways in which the corporation
could have maintained a competitive presence in a given market. Instead of outright
ownership, Maple Leaf Foods could have entered into a joint venture or alliance with
another corporation in order to service a particular market. Alternatively, it could have
simply signed a long-term contract with a firm operating in that market.1
How would you evaluate Maple Leaf’s corporate strategy? Is it reall y
increasing the competitiveness of its individual business units over and above what they
could achieve otherwise? If not, what should change? Should Maple Leaf Foods exit the
agribusinesses to narrow its scope, or should it enter the food retail business to broaden its
scope? If scope expansion is warranted, should Maple Leaf Foods own a business unit
serving the food retail market? Or would the corporation be well advised to sign a long-term
contract? The objective of this note is to provide you the basic tools to answer these
questions. We will discuss two tests you should employ—one to help you answer the scope
questions, the other to tackle the ownership issues.
To assess the choice of markets in which a corporation maintains competitive presence,
we will employ the better-off test, which asks:
Better Off Test: Does the presence of the corporation in a given market
improve the competitive advantage of other business units over and
above what they could achieve on their own?
A negative answer to this question suggests that the corporation should exit the market. An
affirmative answer means that a simultaneous presence in multiple industries is beneficial.
It does not imply, however, that the corporation should necessarily own a business serving
a given market. To examine whether the corporation should own a given business, we will
apply the ownership test, which asks:
Ownership Test: Does ownership of the business unit produce a
greater competitive advantage than an alternative arrangement
would produce?
Only when both tests are satisfied should we conclude that a corporation made an
appropriate decision to own a business unit in another industry. A positive answer to the
better-off test accompanied by a negative answer to the ownership test signifies that the
corporation should maintain a competitive presence in an industry but should not pursue full
ownership (e.g., use a license, alliance, etc.).
The logic behind these tests is straightforward, but it is very difficult to establish whether
the conditions required by each test are actually satisfied. For starters, we are asked to
compare a condition we can observe to a condition we cannot observe. For example, if we
look at Maple Leaf Foods’s agribusiness unit, which is already owned by the corporation, we
have to project the competitive advantage of this business unit if it were separated from the
corporation. Since we cannot do so directly, we could identify a freestanding agribusiness
unit and compare it to the unit owned by Maple Leaf Foods. It is not always clear that two
such businesses are directly comparable, however, due to possible differences in the resources
they possess.2 To overcome these problems, we will focus on key drivers that are likely to
enable the better-off and ownership tests to be satisfied.
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We b e gi n to examine these drivers in t h e context of horizontal diversification.
Horizontal diversification is simultaneous ownership of two or more units that utilize a
similar set of tangible and intangible resources. In the case of Maple Leaf, the meat
processing unit and gourmet food processing businesses are horizontally related in that they
do not supply or purchase goods or service from the other.
3
Horizontal Diversification
The Better-Off Test
Economies of scope
One of the key conditions that will satisfy the better-off test in a context of horizontal
diversification is the presence of economies of scope. Economies of scope exist if the total
cost of producing two goods jointly is less than the combined cost of producing each product
separately. Formally, if C denotes the total cost of production, Y1 is the output of product 1,
and Y2 is the output of product 2, then economies of scope will be present if
C(Y1, Y2) < C(Y1, 0) + C(0, Y2)
Economies of scope are most frequently encountered when a corporation possesses an
asset that is not fully utilized in production of a single product.3 Such assets can be tangible,
such as manufacturing plants or distribution channels, or intangible, such as skills or
research-and- development-generated knowledge that can support multiple products.
Consider an example from the automotive industry, where firms often need to invest in
large and expensive stamping facilities that exhibit economies of scale. Such facilities can
stamp auto bodies as well as light-truck bodies. Assume that neither autos nor light trucks
generate sufficient market demand to exhaust the economies of scale. If the facilities
produced only auto bodies or only light- truck bodies, they would never reach the volume
required for maximum efficiency. When both body types are produced jointly, however, the
facilities can reach sufficient volume. As a result, production costs will be lower than they
would be if the two body types were manufactured separately. Consequently, a joint
production of auto bodies and light-truck bodies allows the two businesses to gain greater
competitive advantage than auto manufacturers could achieve if they produced auto bodies
and light trucks separately.
Similar analysis can be applied to intangible assets. To return to the Maple Leaf Foods
example, if knowledge about efficient processing of meat is applicable to the production of
gourmet food, the meat processing unit can transmit ideas about efficient methods to the
gourmet food unit (or visa versa). As a consequence, the gourmet food unit will benefit from
lower production costs, which will in turn improve its competitive advantage.
Cross-selling The logic of economies of scope formalizes the benefits of horizontal
diversification in terms of cost advantages. These benefits can also be formulated in terms of
total willingness-to-pay advantages. Formally, if R denotes total revenues, then cross-selling
benefits exist if
R(Y1, Y2) > R(Y1, 0) + R(0, Y2)
Cross-selling benefits explain joint sales but not why these sales have to be undertaken by
a single corporation. Two separate organizations can contract to cross-sell their products, as
exemplified by airline code-share agreements. Similarly, economies of scope explain joint
production but not why joint production must be within the confines of a single
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The Ownership Test
4
Cross-selling benefits are most likely to arise in one-stop-shop situations—particularly
when a single point of contact for sales, service, and other support is desirable. For example,
IBM’s corporate strategy of providing a complete solution to firms’ IT needs, including
hardware, software, and service, is based on this benefit. Cross-selling benefits also arise
when reputation is important. Consider Honda’s automobile, motorcycle, and powerequipment businesses. To the extent that customers have similar needs and preferences in
cars, motorcycles, and lawnmowers—high reliability, high durability, high fuel efficiency,
and low emission levels—the three businesses have an opportunity to exploit Honda’s
reputation for reliable, durable, and fuel-efficient machines.4
corporation. If it is possible to write a contract to share the inputs that yield economies of
scope, joint production does not require multi- product organization. To return to our
automotive example, the automobile manufacturer could own the stamping facilities, and the
truck manufacturer could contract for the requisite number of truck bodies to be stamped
there. Conversely, the truck manufacturer could own the stamping facilities, and the
automobile manufacturer could contract for automobile bodies to be stamped there. Or a
third firm could own the stamping facilities and contract its services to both manufacturers. If
any of these solutions provide an efficient means for firms to exchange, the ownership test is
not fulfilled. Consequently, there is no reason to integrate into a single corporation even if
economies of scope exist.
Contractual arrangements will not work, however, for all types of exchanges. The
difficulties will be particularly acute when firms try to share intangible assets, such as
manufacturing or management skills. Consider Maple Leaf’s meat processing business
whose excellent food processing skills are also applicable to gourmet food processing both
of which produce different types of products. The meat processing unit could advertise that
its expertise has reduced its annual manufacturing costs by $50 million and that it is willing
to impart this knowledge to gourmet food processing for $10 million. The proposed deal
potentially creates value for both parties, but the gourmet food producers do not know
whether the meat processing unit’s skills will really reduce their manufacturing costs. Its
claims might be worthless or might even harm the manufacturing process.5
To protect themselves, the gourmet food processing firms might insist that the meat
processing unit explain its manufacturing secret and how it is implemented. If the gourmet
food unit were to disclose this information, however, other food processing unit producers
would learn what to do and no longer need to pay for acquisition of the skills; they could
simply claim to have come up with the idea themselves and proceed to implement it. In
anticipation of this problem, the meat processing unit is unlikely to share its knowledge prior
to signing a contract. This dilemma is known as the fundamental paradox of information—
the prospective purchaser cannot know its value until the information is revealed, at which
point he has in effect acquired it without cost.6
Thus, the gourmet food manufacturers will not want to buy such assets without
understanding their value, but the meat processing unit will not disclose such information for
fear that the gourmet food manufacturers will not pay for it. Consequently, market
exchanges of skills and other intangible assets are likely to fail. These market failures create
an opportunity for a corporation to arrange an exchange that would not occur through
markets. If the meat processing unit and the gourmet food unit are jointly owned by a single
corporation, as in the case of Maple Leaf Foods, manufacturing or managerial skills can be
more easily transferred between the two units. The meat processing unit can disclose
information with confidence that it will receive appropriate compensation. In these
circumstances, the ownership test is satisfied.
Vertical Integration
We now turn to an analysis of drivers that satisfy the better-off and ownership tests in a
context of vertical integration. Vertical integration is simultaneous ownership of two or more
units wherein the outputs of some units become inputs for other units. We typically refer to
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5
You should note that while many intangible assets will satisfy the ownership test, not all
will. Consider, for example, a blueprint for a special device or a formula for a chemical
compound. Since the buyer is able in both cases to recognize the value of the asset, it is
possible for buyer and seller to write a contract for market exchange. In such cases, the
ownership test will fail, and integration into the buyer’s corporation will not be necessary.
In deciding whether the ownership test is satisfied, therefore, you should focus not on the
nature of the good exchanged but on the presence or absence of obstacles to a contractual
relationship.
the producer of such outputs as upstream and the users as downstream. In the case of Maple
Leaf Foods, the agribusiness unit and the slaughterhouse unit are vertically integrated in that
slaughterhouse utilizes the output of agribusiness; the agribusiness is upstream, and the
slaughterhouse is downstream. Similarly, the meat processing and gourmet food units are
vertically integrated with the slaughterhouse unit, since both utilize meat as inputs; in this
case, the slaughterhouse is upstream, and the meat processing and gourmet food processing
units are downstream.
The Better-Off Test
Relationship-specific investments A key condition that tends to satisfy the better-off test
in vertical integration is the presence of relationship-specific investments. Such investments
arise when business units in a vertical relationship tailor their assets to exchanges with each
other in order to reduce production costs or enhance the added value of their goods. Consider,
for example, a gourmet food producer that would like to produce a new high margin food
product that would increase their profits considerably. This process would require them to
invest in new equipment that would enable them to complete the specialized food processing.
However, the specialized equipment requires a supply of high-grade animal stock not widely
available on the market. To make its investment worthwhile, the gourmet food producer
needs to find at least one agribusiness producer willing to invest in facilities to produce highgrade animal stock. Once such an agribusiness producer is identified and the specialized
investments are made on both sides, the overall profits increase. This increase in added value
will be distributed between the agribusiness and the gourmet food producer and thus
contribute to each company’s competitive advantage.
To distribute the value added, the gourmet food processor may promise the agribusiness
producer to pay a high price for animal stock over time so that the agribusiness producer can
recoup its investment. However, such an agreement is problematic. Once the agribusiness
producer builds the new supplies and facilities, the gourmet food producer can renege on its
promise and refuse to pay more than the marginal cost for the specialized meat cuts. Since
no other businesses want the meat cuts, the agribusiness will have no option but to sell its
products at the marginal cost, failing to recoup its original investment. Thus, even though an
investment in production of specialized meat would enable both producers to earn higher
margins, the agribusiness producer’s fear of being taken advantage of will preclude the
investment.
Double marginalization The third condition likely to satisfy the better-off test arises
when two firms in a vertical relationship each possess market power. When both the
upstream and downstream firms have monopoly power and each firm reduces output from the
competitive level to the monopoly level, creating two deadweight losses. Following a merger,
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Downstream free riding A related condition likely to satisfy the better-off test occurs
when firms free ride on the efforts of their competitors. Consider the relationship between a
supplier and retailers of consumer goods. Suppose that there are two types of retailers: one
provides customers thorough information on the product and excellent customer service,
the other merely sells the product. The no-frills retailer has a clear cost advantage and can
charge a lower price. Customers are thus likely to seek product information from a higherquality retailer but ultimately to purchase from the no-frills retailer. As a consequence, the
high-quality retailer will be disadvantaged and will be likely to drop its services. This
decision could hurt the manufacturer by decreasing overall demand for the product. Thus, in
order to preserve customer service, the manufacturer might have to merge into retailing.
6
Joint ownership of agribusiness and gourmet food production might be helpful here. Joint
ownership by a single corporation would assure the agribusiness unit that the gourmet food
unit will not take advantage of a relationship-specific investment. Consequently, it is more
likely to make such an investment, enabling the cardboard business unit to obtain higher
prices from its customers. Thus, joint ownership of agribusiness and gourmet food
production can contribute to the competitive advantage of the gourmet food business unit.
the vertically integrated firm can collect one deadweight loss by setting the downstream
firm's output to the competitive level. This increases profits and consumer surplus. If the
firms merged, however, the supplier would cease to capture surplus and instead transfer
goods and services at marginal cost. This scenario would allow for lower output prices and
expansion of output, both of which increase the competitive advantage of the buyer.8
The Ownership Test
The three conditions discussed above satisfy the better-off test and help us understand
when a firm should operate simultaneously in more than one industry along the vertical
chain. However, as in the case of horizontal diversification, passing the better-off test is
insufficient to conclude that a firm should actually own the upstream or downstream
business. A reasonably simple contract can be written to achieve the same purpose. Only
when significant contractual difficulties are likely to arise would we expect a firm to acquire
along the vertical chain. In fact, as we will see below, very few conditions that pass the
better-off test also pass the ownership test.
Relationship-specific investments
Recall our discussion of relationshipspecific investments between independent agribusiness producers and a gourmet food
producers. Such investments could improve the competitive advantage of both firms but
create vulnerability to opportunistic renegotiation, making such investments unlikely. We
may consequently conclude that the firms should integrate to preclude renegotiation and to
ensure that the investments are undertaken. A simpler solution, however, is a long-term
contract between the parties. If the firms can specify the price at which they will exchange
and create safeguards against future opportunistic renegotiation, they can assure each other
that there will be no such renegotiation. In reality, many such contracts exist. For example,
transactions between coal producers and coal-burning plants, characterized by substantial
relationship-specific investments, are typically governed by long-term contracts.9 Both
parties can enforce detailed contracts specifying prices, quality, and terms of delivery. If
specifying these basic parameters in a contract is impossible, the ownership test is satisfied.
In such cases, joint ownership of upstream and downstream may be the only means of
encouraging relationship-specific investments.
Downstream free riding A similar analysis can be applied to downstream free riding.
Vertical integration seems to be an effective means of preventing the free-riding problem,
but a host of contractual solutions could be employed instead. The upstream producer could
force all retailers to charge the same price. (This practice is generally illegal in Canada and
the United States.) Another alternative is to do business only with retailers that provide the
required services. A less extreme version of this strategy is to provide better treatment—
faster restocking or joint advertising campaigns—to retailers that provide service. If none of
these options is feasible, the ownership test is satisfied and the firms should integrate.
The preceding discussion argues that the ownership test is satisfied only if there are
formidable barriers to a contractual solution. Implicit in that discussion is the assumption that
the institutional environment allows for writing and enforcing reasonably simple contracts. If
two firms operating in such an environment write a simple contract and either party fails to
live up to its terms, the contract can be enforced through well-developed institutions such as
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The Ownership Test in Different Legal Environments
7
Double marginalization Finally, the contractual analysis can be applied to the doublemarginalization problem. One simple contractual solution is for the upstream firm to set its
price at the marginal cost of producing the good and to charge the downstream firm a fixed
fee as compensation for giving up monopoly profits. This solution is commonplace in the
form of franchise fees. Again, for double marginalization to be a compelling motive for
vertical integration, there must be a reason why such contracts are not feasible.
courts. In many developing countries, however, these institutions may be weak, corrupt, or
absent. In such environments, each party may fear that the other will fail to honor its
commitments. They may thus be wary of entering into market exchanges, even though they
would not hesitate to do so in a different legal environment. In these contexts the ownership
test will be satisfied.
One important implication is that firms in developing countries may tend to have a
broader scope than their counterparts in developed countries.10 In other words, Maple Leaf
Foods of China, or Poland may be broader in scope than its Canadian equivalent. By
integrating exchanges into the firm, the broadly diversified corporations typical of those
countries protect their business units from the perils of market exchanges in uncertain legal
environments and thus secure a corporate advantage for their business units.
Costs of Ownership
Finally, we should bear in mind that even when the better-off test and the ownership test
are both satisfied, we cannot always be certain that horizontal or vertical integration will
enhance the competitive advantage of individual business units. By integrating these business
units into a single corporation, we may protect them from the perils of market exchange and
contractual problems. But we may also expose them to a host of organizational costs that
could outweigh the economic benefits of integration. Thorough consideration of these issues
would require another 10 pages; this note will merely draw your attention to a few of the
most important considerations. These issues are covered in great detail in the EC course on
corporate strategy.
Incentive costs Perhaps the most noteworthy organizational cost of integrating two or
more units into a corporation is incentive costs. When businesses are not integrated, they
must compete with other firms in their markets and thus continually strive to provide the
best-quality products at the lowest prices. When businesses are integrated, however, the
corporate office can mandate transfers of resources between business units at prearranged
transfer prices. A consequence may be weakened incentive for the business units to be the
most efficient producers.
Capital misallocation When businesses are owned separately, they are likely to make
capital allocation decisions independently. However, when capital-allocation decisions are
made by the corporate office, a business unit may find itself with too little or too much
capital. To the extent that the corporate office acts on biases in the allocation of
resources, capital misallocation is likely to occur.
Power When the corporate office makes decisions about capital allocation and transfer
prices, substantial power differences between business units are likely to arise. Thus,
business-unit managers can be expected to engage in power games to counteract the ordained
power structure. To the extent that these games undermine trust and cooperation between
businesses, the corporation will suffer and the corporate advantage will be eroded.
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By now you should understand the basic principles underlying value-creating corporate
diversification. First, a corporation contemplating a competitive presence in another industry
should pass the better-off test. In a context of horizontal diversification, economies of scope
are most likely to lead to a conclusion that the better-off test is satisfied. In a context of
vertical integration, the better-off test is most likely to be satisfied in the presence of
relationship-specific investments or the possibility of downstream free riding. On its own,
however, the better-off test is insufficient to justify corporate diversification.
A complete
analysis must also apply the ownership test, which asks whether the firm should acquire a
business unit in another industry or merely enter into a long-term contract. This test applies
8
Conclusion
equally to horizontal diversification and vertical integration. If there are significant obstacles
to negotiating and enforcing such a contract, as in the case of certain intangible assets, full
acquisition is likely to yield greater benefits than contractual arrangements. If a contract can
be signed and enforced, however, joint ownership is unlikely to be justified. The advantage
of joint ownership over contracts will vary not only with types of exchanges but also with
institutional environments for enforcement of contracts. In countries where enforcement is
unlikely, joint ownership will typically be preferable to contracts. Finally, the benefits of
ownership should be weighed against the inevitable costs of bureaucracy.
Managing Corporate Strategy under Unrelated Diversification
Companies that have invested in an unrelated diversification strategy are usually large
investment holding firms. These corporate entities have far fewer ways of creating
competitive advantage because there is not a natural strategic link or synergy between the
two firms. The competitive synergies that allow corporations having an unrelated
diversification strategy to increase their competitive advantage are related to the synergies
between the capabilities, skills, resources, etc. in the corporate head office and the individual
firms.
An example of a firm having unrelated diversification is Berkshire Hathaway. Berkshire
Hathaway, a $100 billion plus firm managed by Warren Buffet, owns firms in furniture retail,
financial services, jewelry, aviation services, home building, etc. These firms have such little
strategic overlap, few top managers in the underlying businesses have ever communicated
with one and another. GE is another example of a diversified firm. They have businesses in
the financial services, aviation equipment production, healthcare equipment, power
equipment, and appliances. Both of these firms have been able to increase the competitive
advantage of their firms by having the corporate head office offer unique capabilities,
services, assets, etc. to the separate business units.
When assessing the nature of unrelated diversification, the rules are largely the same. One
should apply the better off test and the ownership test as was described above to see if the
corporate strategy creates value for the firm. The key is not looking within and between the
individual business units, but now looking within the corporate head office. It should be
noted that firms having other types of diversification (e.g., related, geographic, and vertical)
may also have value creating synergies that exist in the corporate head office and satisfy the
two corporate strategy investment tests.
2
Almost all of these programs require considerable economies of scale before they are economically viable.
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The better of test is satisfied in all cases because the companies have improved
management, efficiencies and processes and products through innovation. The only caveat to
this better off test is how much do corporations spend on providing these services and
processes. In general, it would appear the value produced by these services far out ways the
cost of offering the programs2. Six Sigma alone has been reported to have saved GE in excess
of $1 billion11.
9
The unique services and capabilities that GE corporate offers to its diverse business units
include the following:
 Leadership and Management Development Programs: GE has a number of training and
evaluation programs and processes that it uses within its companies.
 Efficiency and Effectiveness Programs: GE has two key processes, six sigma and
work-out sessions that identify and drive out inefficiencies. These programs
 Creating & Sharing Innovative Ideas: GE has a variety of communication and
collaboration approaches aimed at developing new innovative ideas at all levels of
business. When a firm comes across an innovative idea that works they share it very
quickly with their other
The ownership test is a more complex. However, one could argue that most firms would
not be willing to pay the price of these sometimes abstract services. Secondly, most of the
processes require an integrated culture to enable them to work most effectively. Finally, there
is the potential for a free riding effect to occur where users of the services (if used in the open
market) somehow are able to replicate or transfer these processes effectively into their
organizations. If all competitors develop these competitive advantages they tend not to
provide any extra value to the firms using them because competition will minimize the ability
for a firm to extract higher value.
Endnotes
1 For full analysis of the various decisions that lead to corporate advantage, see Collis
and Montgomery (1998).
2 For example, Villalonga (2004) provides evidence that stand-alone business units may
be of higher quality, suggesting that straightforward comparisons of stand-alone businesses
and corporate business units may be misleading in assessing the appropriate scope of a firm.
3 See Panzar and Willig (1981) and Bailey and Friedlaender (1982) for a complete
discussion of factors that yield economies of scope.
4 Montgomery and Wernerfelt (1992) provide a detailed analysis of the effects of
reputation.
5 The contractual problem described here is the adverse-selection problem. Akerlof
(1970) first recognized and illustrated this problem in the market for used cars. Adverse
selection stems from information asymmetry: to employ Akerlof’s example, the owner of a
used car has access to far more information about its quality than does any potential buyer.
Without accurate information on the quality of a given car, buyers will tend to pay the same
amount for all cars with the same observable attributes. Only owners whose estimation of
their cars’ value is less than the average price will sell their cars, while owners of highquality cars will not find it attractive to enter the market. Consequently, only poor-quality
goods will be available for sale, and the market for high- quality goods will fail.
6 See Arrow (1971), p. 152.
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8 One other condition, vertical foreclosure, is likely to satisfy the better-off test. The three
conditions described in the text satisfy the test due to efficiency considerations, but vertical
foreclosure is likely to do so even if there are no efficiency benefits. Consider a market
whose supply of inputs is competitive before a merger. Suppose that, after a merger, the
upstream division of the now-integrated firm refuses to supply inputs to rivals of its
downstream division. This foreclosure of rivals means that other suppliers will face less
competition. As a result, they may be able to increase profits by raising their input prices to
the unintegrated downstream firms. These higher prices benefit the downstream division of
the vertically integrated firm. If rivals’ input costs increase, they will be forced to reduce
production and to raise the prices they charge in the downstream market. This reduction in
competition allows the downstream division of the integrated firm to increase its market
share and its price. Thus, the profits of the vertically integrated firm can rise, even if no
production-efficiency benefits flow from vertical integration. As this description illustrates,
10
7 Note that this argument applies only to markets whose participant firms possess some
market power. A supplier in a competitive market already prices at marginal cost.
Similarly, a buyer that operates
in a competitive market is also pricing at marginal cost. Thus double-marginalization
justifications do not apply.
the rationale behind vertical foreclosure is complex. Thus, although vertical foreclosure has
elicited substantial academic interest, there is little real-life evidence that vertical
foreclosure is an important driver of vertical integration (Ordover, Saloner, and Salop,
1990).
9 See Joskow (1987) for details.
10 See Khanna and Palepu (2000).
11 Quality Digest, (2001), Six Sigma Survey
References
Akerlof, George. "The Market for 'Lemons': Qualitative Uncertainty and the Market
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