Chapter 2
Firms and Markets
School of Economics and Business
Administration
Universidad de Navarra
Economics of organizations
 Recall: 12th of April midterm exam (elective)
 6 points. Concepts. Revise the theories of
vertical and horizontal integrations.
 4 points. Exercise: Specific assets, holdup and
vertical integration.
Structure of the chapter
 2.1. Efficiency and limits of the market
 2.2. Transaction Costs and the holdup problem
 2.3. Behavioral approach to the holdup problem
 2.4. Vertical and Horizontal Boundaries of the Firm
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Long term contract and implicit contract
- An implicit contract is an tacit and informal
agreement that does not appear in any legally
enforceable document.
-
In that case, parties may decide to write long term
contracts to sustain agreements that are not legally
enforceable. It is possible given that one party can
threaten the other with future punishments in case of
no compliance of the initial agreement.
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Business alliances
-
-
In a business alliance, several firms agree to collaborate
in a project and exchange information and other inputs
(General Motors – Toyota in the 80s).
Similar to market transactions as firms are independent
entities, but a business alliance implies a greater level of
cooperation, coordination and information transmission
than in a market transaction making the alliance closer to
a situation of vertical integration.
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Franchising
-
-
In a franchise agreement, the franchisee operates a business using
the brand of a franchisor and frequently buys inputs or final
products to the franchisor.
Examples: Fast food (McDonalds, Burger King, Telepizza).
Automobile industry (car dealerships).
The payment scheme is usually a fixed payment plus a percentage
of sales.
It is not a case of vertical integration since the franchisee is not
the employee of the franchisor.
Franchising implies holdup problems and agency costs.
2.4. Vertical boundaries of the firm
Alternatives to vertical integration
 Franchising puzzle
Franchising among gas stations that provide repair
services is more frequent that for gas stations that do
not.
Why?
2.5. Horizontal boundaries of the firm
Economies of scale
 Definition: a production process exhibits economies of
scale over a range of output if the average cost
decreases in this range of production levels.
AC(Q)
a
Average
cost function
Q*
Optimal size
of the firm
Q
2.5. Horizontal boundaries of the firm
Economies of scope
 Definition: There are economies of scope if a single firm
producing two goods X and Y has a lower average cost than
two separate firms, each producing one of the goods.
2.5. Horizontal boundaries of the firm
Sources of economies of scale and scope
 Economies of scale and scope appear because of the
existence of fixed costs that are divided into a larger
number of units as the volume of production increases.
1. Indivisibilities. (e.g. Transport).
2. Access to an efficient technology. (e.g. Machinery).
3. Stocks and uncertainty. (e.g. Seller out of stocks).
2.5. Horizontal boundaries of the firm
Sources of economies of scale and scope
4. Research and development costs (e.g.
Pharmaceutical industry)
5. Purchasing and bargaining power.
6. Publicity expenses (e.g. Sony)
2.5. Horizontal boundaries of the firm
Sources of diseconomies of scale and scope
1. Labor costs. (Empirical evidence).
2. Incentives and bureaucracy. (Coordination and
motivation costs).
3. Non-replicability of entrepreneurial talent. (Coase
1937).
4. Legal motives.
Firm boundaries
Case I: EDS – Continental Airlines
 Description of the case: managing synergies.
- System One is a firm controlled by Continental Airlines
that operates the system of electronic reservations and
other information.
- System One deals with 20% of the total reservations of US
Airline Companies.
- Until 1991, System One is also a data provider to 170
airline companies.
-
a) Why airline companies do not operate their own
reservation service?
Firm boundaries
Case I: EDS – Continental Airlines
 In 1991, the firm Electronic Data Service takes the control
of System One.
- Electronic Data Service is a leading provider of
information services in the banking and energy sectors.
-
b) Do you think taking the control of System One is
profitable operation for Electronic Data Service? Why?
Firm boundaries
Case II: Rolm - IBM
 Description of the case: managing incentives.
- Rolm is a small firm in the Sillicon Valley with rapid
growth in the computer sector (computers, information
systems.).
- Rolm has a very peculiar corporate culture: “no dressing
codes no time schedules”. However, employees work a
lot.
- To maintain the corporate culture: a large number of small
divisions and employees in Rolms’ stocks.
- Rolm compete with giants like AT&T y Northern
Telecom.
Firm boundaries
Case II: Rolm - IBM
 The management of Rolm decides to ask for the support of
IBM by giving IBM the possibility to take the control of
Rolm with the restriction of not modifying the
management style of Rolm.
Do you think taking the control of Rolm is a good decision
for IBM?
Firm boundaries
Case II: Rolm - IBM
 Do you think taking the control of Rolm is a good decision
for IBM?
- Problem: conflicting sales strategies between the two
firms. Price differentiation impossible for IBM. Less
flexibility for Rolm’s employees implying lower
commissions. Many salespersons decided to leave the
integrated firm.
- System of incentives such that Rolm’s paid with IBM
stocks.
- In 1986 most executives left the firm.
- In 1988 IBM sold Rolm.
Firm boundaries
Case III: General Motors - EDS
 Description of the case: profit sharing.
- In 1984, General Motors takes the control of Electronic
Data Service (EDS), a firm of information services.
- The success of EDS depends crucially on the motivation of
its salespersons paid bonuses in stock options.
- General Motors wants to acquire EDS to improve its
information services and then its production technology.
What do you think about the decision of General Motors?
Firm boundaries
Case III: General Motors - EDS
-
-
GM commits to maintain the management style of EDS
paying employees of EDS with stock options of EDS that
GM decided to maintain as a special class of actions of
GM.
In 1985, EDS profits increased by 400%.
What is the potential problem?
Firm boundaries
Mergers or myths
- A study by the University of Ohio State assesses the
failure of mergers to 60%.
a) How should we measure the success of a merger?
Firm boundaries
Mergers or myths
a) How should we measure the success of a
merger?
Example AOL – Time Warner
Firm boundaries
Mergers or myths
-
A study by the University of Ohio State assesses the failure
of mergers to 60%.
-
b) Why do mergers fail?
Report by McKinsey:
“Too much attention has been devoted to financial and
legal aspects of mergers but it is well recognized that the
crucial element for the success of a merger is the human
resource management”.
Firm boundaries
Mergers or myths
b) Why do mergers fail?
1. The human factor and the integration of employees.
Managing corporate cultures conflicts.
2.
Power conflicts.
3. Loss of talent (loss of control, uncertainty).
- American Management Association: 47% of the senior
executives leave the firm in the year of the merger.
- Wall Street Journal: 50-75% of the executives think to
leave the integrated firm within 3 years after the merger.
4.
Loss of customers.
Firm boundaries
Mergers or myths
b) Why do mergers fail?
5. Executives usually overestimate the potential
synergies associated to mergers, overconfidence
(Synergies?).
6. Prestige and high salaries of top executives.