ECON 696: Managerial Economics and Strategy
Lecture Notes 4: Organizing Vertical Boundaries: Vertical Integration and Its
Alternatives
This chapter is a final look at the decision of a firm to vertically integrate. Chapter three
talked about the benefits and costs of buying inputs. Chapter four talked about problems
involved in contracting for relationship specific production. This chapter talks about
efficiency tradeoffs in the make or buy decision, alternatives to make or buy and the
importance of long-term relationships between firms and their suppliers.
As with the other chapters, the important ideas here are the general characteristics that
make vertical integration more or less desirable. While they can't necessarily be applied
absolutely, an understanding of which characteristics are most important will help you
predict when vertical integration is more or less likely to be successful. The hope is that
you will be able to apply these principles to the memo assignment dealing with vertical
integration.
The Technical Efficiency/Agency Efficiency Tradeoff
The chapter goes to some effort to describe a tradeoff that firms can make between
technical efficiency and agency efficiency. Technical efficiency is achieved when things
are produced as inexpensively as possible. Agency efficiency is achieved when the
transactions costs involved in a process are minimized. This provides a framework in
which to examine problems of vertical integration.
The easiest way to achieve technical efficiency is to buy, because if the market for the
input is sufficiently competitive, the price of the input should be close to its minimum
average cost.
The easiest way to achieve agency efficiency is to make, because then you avoid all sorts
of transactions costs that would come with outside contracting.
The important thing to remember (and the point of Figure 4.1 in the text) is that as assets
or investments become more relationship specific the gains to and likelihood of vertical
integration (making rather than buying) become greater.
Again,
As assets or investments become more relationship specific, the gains to
and likelihood of vertical integration become greater.
Four principles are important to consider when looking at real world situations:
1. If economies of scale are large, it is probably better to buy inputs rather than make
them because one large firm will likely have lower average costs than would a smaller,
vertically integrated production facility.
2. Larger firms are more likely to demand enough of an input to make vertical
integration worthwhile, with the result that firms with a larger share of a market are
more likely than their smaller competitors to be vertically integrated.
3. The more specific an asset, the more vertical integration makes sense to avoid holdup
problems.
4. The more competitive an input market, the less reason there should be for vertical
integration because the price paid will be closer to the minimum average cost, offering
little or no opportunity for improvements in technical efficiency.
Middle Ground Options Between Make and Buy
We have already started to establish a continuum along which make or buy options might
be considered in terms of how involved the firm is with the production of its inputs. At
one extreme is buying in spot markets, then buying under contract. These are both forms
of buying, although purchasing in spot markets implies less of a relationship between the
two parties than does a contract. At the other extreme is complete vertical integration.
On a line, they might look like this:
There are other options between "Buying Under Contract" and "Vertical Integration"
although where they might lie in relation to one another is probably a matter of opinion.
Among them are:
1. Tapered Integration
This occurs when a firm works with both external and internal suppliers or distributors
along the vertical production process. One advantage is that, like having multiple
suppliers, it reduces the likelihood of a hold up problem. Another is that it is easy to
assess the performance of an internal supplier by auditing their costs and reliability and
comparing them to the benchmark of the external provider. Tapered integration is likely
to be less successful when there are large economies of scale and one large supplier
would gain significant advantages over several smaller suppliers.
One example is fast food companies that have both franchise restaurants and centrally
owned restaurants. It may be that this tapering is designed with another intent. Quality is
critical to both an individual restaurant and to others in the national chain. If a person
gets a bad meal at one particular restaurant, not only will they not visit that particular
restaurant ever again, they will also be less likely to visit others in the chain. At a
restaurant whose business is primarily returning customers (like at a neighborhood
hamburger place) the owner will have a sufficiently strong incentive to monitor quality,
knowing that several poor meals will severely reduce his future business. At a restaurant
whose business is primarily one-time customers (like at an airport or along a remote
stretch of interstate highway) the owner will have less incentive to monitor quality,
knowing that most customers won't be back anytime soon. The lower quality at the
second restaurant will threaten the reputation of the national chain, so the chain might
choose to operate the second type of location itself while allowing franchises in locations
where most business comes from repeat customers.
2. Strategic Alliances and Joint Ventures
Under these types of organizations, firms either join forces for a particular project or
create a new company which is jointly owned and to which they both contribute
resources. These organizations arise when contracting would be too difficult due either
to the large scope of the project or a high degree of uncertainty about what actions and
expertise will be necessary for success.
Establishment of these relationships is typically very time consuming and worthwhile
only if there is the expectation of large benefits, benefits which are likely to accrue over a
long period of time. While the lack of specific and enforceable contracts in these
organizations might normally lead to various problems, the implied length of these
relationships and the knowledge that opportunistic activity on the part of one participant
would threaten any long term benefits can work to discipline the participants. To put this
another way, the participants work hard to form a relationship for large long term gains
and they don't want to upset it for small short term gains.
3. Collaborative Relationships
Unofficial relationships exist in business. Firms maintain exclusive or consistent
dealings with one another for a variety of reasons that may not seem rational.
In some cases, it may be that managers have social relationships with managers of their
firms' suppliers, and looking elsewhere for inputs would cause these social relationships
to deteriorate.
Reliance on small a circle of suppliers may also be due to lack of information or to risk
aversion. The perceived gains from going outside a circle of known associates to find a
supplier may not be worth the added search costs or the risk of choosing an inferior
supplier. The risks involved in moving to a new supplier may deter a firm from
abandoning a long-standing supplier whose performance has been more or less
satisfactory.
For whatever reasons, firms often have unwritten commitments for long term interactions
with each other and do not stray, even if tempted by attractive new offers. These long
term relationships persist, despite some loss of technical efficiency, due to the gains in
agency efficiency they allow.
Importance of Long Term Relationships
Long term relationships between firms are generally not established contractually.
Rather, they arise over time because they offer significant efficiency gains. There are
several important aspects of long term business relationships.
First, long term business relationships are enhanced by close social as well as business
ties. If two sides are to trust each other, they must both know that there will be high costs
of violating that trust. Incentives to act in good faith are enhanced if there would be
social costs associated with opportunistic behavior. If managers of related firms often
spend leisure time together, a person who violates the trust of others loses not only
business partners, but friends as well.
Long term relationships can reduce both efficiency and agency costs. Efficiency costs
result from a firm vertically expanding and producing an input at higher cost than a
supplier might. In, instead of expanding vertically a firm purchases from a supplier
specializing in production of the input, efficiency costs may be eliminated. Agency costs
result from transactions with suppliers. If a firm has a long standing relationship with its
suppliers, it can be less careful in contracting and monitoring. The supplier will work to
produce a high quality input to avoid jeopardizing the relationship and its long term
gains. Holdup problems will be unlikely.
Long term relationships reduce the risks involved in dealing with new suppliers, as well
as the costs of finding new suppliers.
One thing to be careful of in long term relationships is that the suppliers to whom you are
obligated are relatively efficient. Indeed, if the supply relationship has been
longstanding, the firm may have lost track of what other suppliers might have to offer,
and at some point the cost of staying in the relationship might be too great. A further risk
is that decisions may be made which preserve the relationship at too high a cost. The
book describes keiretsu as relationships among various types of businesses, including
major banks. If banks have close ties with businesses, they can make a lot of bad loans
to good friends and, if they make enough of them, can bring down the entire keiretsu.
Summary
This chapter concludes the section of the text examining vertical expansion and
integration by considering the efficiency tradeoffs involved in make or buy decisions,
some issues in contracting and alternatives to the extremes of buying in a spot market and
complete vertical integration.
The important issues in this chapter are the important characteristics of the input being
considered, the relative abilities of suppliers to provide it, and the potential relationships
between the firm and its suppliers. You should be able to look at situations, assess their
potential for vertical integration and offer an opinion as to which form of relationship
between a firm and its suppliers might be appropriate. Possibilities include:
 spot market purchases
 purchasing under contract
 tapered integration
 joint ventures or strategic alliances
 collaborative relationships
 vertical integration