ECP 6701
Competitive Strategies in Expanding Markets
Vertical Boundaries of the Firm
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Readings
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BDSS Chapter3
Vertical Chain
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Begins with the acquisition of raw materials
Ends with the sale of finished goods/services
Includes support services such as finance and
marketing
Organizing the vertical chain is an important
part of business strategy
Vertical Boundaries of the Firm
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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)
Make versus Buy
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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)
Support Services
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Accounting
Finance
Legal Support
Marketing
Planning
Human Resource Management
Defining Boundaries
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Firms need to define their vertical boundaries
Considerations
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Economies of scale achieved by market firms
Value of market discipline
Ease of coordination of production flows in-house
Transactions costs when dealing with market firms
Reasons to Buy rather than Make
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Market firms (outside specialists) may have
patents/proprietary information that makes low
cost production possible
Market firms can achieve economies of scale
that in-house units cannot
Market firms are subject to market discipline,
whereas in-house units may be able to hide
their inefficiencies behind overall corporate
success (Agency and influence costs)
Economies of Scale
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Economies of Scale
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A given manufacturer of automobiles may not
be able to reach the minimum efficient scale
(A*) for anti-lock brakes
An outside supplier may reach the minimum
efficient scale by supplying to different
automobile manufacturers
Economies of Scale
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An automobile manufacturer would rather buy
anti-lock brakes from an independent supplier
than from a competitor
Minimum efficient scale may be feasible for the
independent supplier but not for an automobile
manufacturer
Economies of Scale
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Will the outside supplier charge c* (its average
cost) or c’ (the average cost for the
manufacturer for in-house production)?
The answer depends on the degree of
competition faced by the supplier
Agency and Influence Costs
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The incentives to be efficient and innovative
are weaker when a task is performed in-house
Agency costs are particularly problematic if the
task is performed by a “cost center” within an
organization
It is difficult to internally replicate the incentives
faced by market firms
Influence costs
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In addition to agency costs, performing a task
in-house will lead to “influence costs” as well
“Internal Capital Markets” allocates scarce
capital
Allocations can be favorably affected by
influence activities
Resources consumed by influence activities
represent “influence costs”
Reasons to Make
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Costs imposed by poor coordination
Reluctance of partners to develop and 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
Role of Contracts
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Firms often use contracts when certain tasks
are performed outside the firm
Contracts list
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the set of tasks that need to be performed
the remedies if one party fails to fulfill its obligation
Contracts
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Contracts protect each party to a transaction
from opportunistic behavior of other(s)
Contracts’ ability to provide this protection
depends on
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the “completeness” of contracts
the body of contract law
Complete Contract
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A complete contract stipulates what each party
should do for every possible contingency
No party can exploit others’ weaknesses
To create a compete 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)
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To enforce a contract, an outside party (judge,
arbitrator) should be able to
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observe the contingency
observe the actions by the parties
impose the stated penalties for non-performance
Real life contracts are usually incomplete
contracts
Incomplete Contracts
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Incomplete contracts
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Involve some ambiguities
Need not anticipate all possible contingencies
Do not spell out rights and responsibilities of parties
completely
Factors that Prevent Complete
Contracting
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Bounded rationality
Difficulties in specifying/measuring
performance
Asymmetric information
Bounded Rationality
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Individuals have limited capacity to
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Process information
Deal with complexity
Pursue rational aims
Individuals cannot foresee all possible
contingencies
Specifying/Measuring Performance
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Terms like “normal wear and tear” may have
different interpretations
Performance cannot always be measured
unambiguously
Asymmetric Information
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Parties to the contract may not have equal
access to contract-relevant information
One party can misrepresent information with
impurity
Contract Law
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Contract law facilitates transactions with
incomplete contracts
Parties need not specify provisions that are
common to a wide class of transactions
Limitations of Contract Law
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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
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Litigation can be time consuming
Litigation weakens the business relationship
Coordination of Production Flows
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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. Some examples are:
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Timing
Size
Color
Sequence
Coordination Problems
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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
Leakage of Private Information and
Outsourcing
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Firms would not want to compromise the
source of their competitive advantage
Well- defined patents can help but may not
provide full protection
Contracts with non compete clauses can be
used to protect against leakage of information
In practice non-compete clauses can be hard
to enforce
Transactions Costs
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If the market mechanism improves efficiency,
why do so many of the activities take place
outside the price system? (Coase)
Costs of using the market that are saved by
centralized direction – transactions costs
Transactions Costs
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Outsourcing entail costs of negotiating, writing
and enforcing contracts
Costs are incurred due to opportunistic
behavior of parties to the contract and efforts to
prevent such behavior
Transactions costs explain why economic
activities occur outside the price system
Transactions Costs
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Sources of transactions costs
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Investments that need to be made in relationship
specific assets
Possible opportunistic behavior after the investment
is made (hold up problem)
Quasi-rents (magnitude of hold up problems)
Relationship-Specific Assets
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Relation-specific assets are essential for a
given transaction
These assets cannot be redeployed for another
transaction costlessly
Once the asset is in place, the other party to
the contract cannot be replaced costlessly,
because the parties are locked into the
relationship to some degree
Relationship-Specific Assets:
Examples
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An aluminum refiner invests in a refinery
designed to process a particular grade of
bauxite ore
The French government invests in
transportation infrastructure for Euro-Disney
Forms of Asset Specificity
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Relation-specific assets may exhibit different
forms of specificity
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Site specificity
Physical asset specificity
Dedicated assets
Human asset specificity
Rent and Quasi-rent
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The term ‘rent” denotes economic profits –
profits after all the economic costs, including
the cost of capital, are deducted
Quasi-rent is the excess economic profit from a
transaction compared with economic profits
available form an alternate transaction
Rent and Quasi-rent
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Firm A makes an investment to produce a
component for Firm B after B as agreed to buy
from A at a certain price
At that price A can earn an economic profit of
π1
If A were to renege on the agreement and B is
forced to sell its output in the open market, the
economic profit will be π2
Rent and Quasi-rent
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Rent is the minimum economic profit needed to
induce A to enter into this agreement with B
(π1)
Quasi-rent is the economic profit in excess on
the minimum needed to retain A in the selling
relationship with B (π1- π2)
The Holdup Problem
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Whenever π1 > π2, Firm B can benefit by
holding up A and capturing the quasi-rent for
itself
A complete contract will not permit the breach
With incomplete contracts and relationshipspecific assets, quasi-rent may exist and lead
to the holdup problem
Effect on Transactions Costs
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The holdup problem raises the cost of
transacting exchanges
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Contract negotiations become more difficult
Investments may have to be made to improve the
ex-post bargaining position
Potential holdup can cause distrust
There could be underinvestment in relation specific
assets
Holdup and Contract Negotiations
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When there is potential for holdup, contract
negotiations become tedious as each party
attempts to build in protections for itself
Temptations on the part of either party to
holdup can lead to frequent renegotiations
There could be costly disruptions in the
exchange
Holdup and Costly Safeguards
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Potential for holdup may lead parties to invest
in wasteful protective measures
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Manufacturer may acquire standby production
facility for an input that is to be obtained from a
market firm
Floating power plants are used in place of traditional
power plants to avoid site specific investments
Holdup and Distrust
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Potential holdups cause distrust between
parties and raise the cost of transactions
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Distrust can make contracting more costly since
contracts will have to be more detailed
Distrust affects the flow of information needed to
achieve process efficiencies
Holdup and Underinvestment
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When there is a holdup, the investment made
in relationship-specific assets loses value
Anticipating holdups, firms will make otherwise
sub-optimal level of investments and suffer
higher production costs
Asset Specificity and Transactions
Costs
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Relation-specific assets support a particular
transaction
Redeploying to other uses is costly
Quasi rents become available to one party and
there is incentive for a holdup
Potential for holdups lead to
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Underinvestment in these assets
Investment in safeguards
Reduced trust
Summary
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Production activities flow from upstream suppliers to
downstream manufacturers, distributors, and retailers
(vertical chain).
The “make or buy” problem determines the vertical
boundaries of a firm.
The solution to this problem depends on option leads
to most efficient production.
This requires an assessment of the cost and benefits
of using the market.
Summary
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Market firms can exploit economies of scale to
produce a component cheaper.
Market firms are subject to competition which
encourages efficiency and innovation.
Vertically integrated firms might face agency
and influence costs.
Summary
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Use of market transactions entails coordination
problems (especially for production of inputs
with complex design requirements).
Use of market transactions may lead to lose
control of valuable private information.
Use of market transaction might entail
contracting costs.