Vertical Boundaries

Of The Firm
Dr Abhijit Sharma
Economics of Industry: Lecture 4
MAN0201M

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Lecture overview
In this lecture, we will consider:
Vertical integration and the vertical chain"
Make versus buy decision"
Role of contracts"
Agency costs and influence costs"
Transactions costs"
Asset specificity "
The hold-up problem"
Reference Besanko et al, Ch 5."

The Vertical Chain

The vertical chain
begins with the acquisition of raw materials and
ends with the sale of finished goods/services.
Organising the vertical chain is an important part
of business strategy
Vertically integrated firms (BP) perform all the
tasks in the vertical chain in-house.
Vertically disintegrated firms (Nike) outsource
most of the vertical chain tasks.

Vertical Boundaries of the Firm

Vertical boundaries of the firm demarcate
which tasks in the vertical chain are to be
performed inside the firm and which to be
out-sourced.
The choice is between the market and the
organisation is a make or buy decision.

Make versus Buy

There is a continuum of possibilities between the
two extremes
Arms length transactions
Long term contracts
Strategic alliances and joint ventures
Parent/subsidiary relationship
Activity performed internally

Vertical Chain of Production

Some Make-or-Buy Fallacies

Firm should make rather than buy assets that
provide competitive advantages
Outsourcing an activity eliminates the cost of that
activity
Making instead of buying captures the profit
margin of the market firms
Vertical integration insures against the risk of high
input prices
Making ties up the distribution channel and denies
access to the rivals
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Make-or-Buy
A firm may believe that a particular asset is
a source of competitive advantage
If the asset is easily available in the market
it may not confer significant advantage
It should not matter if the costs of
performing an activity are incurred by the
firm (Make) or by the supplier (Buy)
The relevant consideration is whether it is
more efficient to make or to buy
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Vertical Integration
The suppliers profit margin may not represent any
economic profit, and profit margin should pay for the
capital investment and the risk borne
If the supplier is earning economic profit, is there a
reason for its persistence?
Market competition should eventually erode away any
economic profit
Instead of vertical integration, long term contracts can
be used to reduce input price risk
Forward or futures contracts/ capital reserves can also
be used to deal with input price risk

Reasons to Buy
Market firms may have patents or
proprietary information that makes low cost
production possible
Market firms can achieve economies of
scale that in-house units cannot
Market firms are likely to exploit learning
economies

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Economies of Scale
Production Costs and the Make-or-Buy Decision

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Economies of Scale
A manufacturer of automobiles needs A units
An outside supplier reaches minimum efficient scale
(A*) by supplying to different automobile
manufacturers
Cost is lowered by using the outside supplier
Minimum efficient scale may be feasible for the
independent supplier but not for an automobile
manufacturer.
Will the outside supplier charge C* (its average cost)
or C (the average cost for the manufacturer for inhouse production)?
The answer depends on the degree of competition
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faced by the supplier

Agency Costs
Agency costs are due to slacking by employees
and the administrative effort to deter slacking.
When there are joint costs, measuring and
rewarding individual unit s performance is difficult.
Difficult to internally replicate the incentives faced
by market firms
Difficult to evaluate efficiency when a task is
performed by a cost center within a firm

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Influence Costs
Performing a task in-house will lead to
influence costs.
Internal Capital Markets allocates scarce
capital within the firm
Allocations can be favorably affected by
influence activities
Resources consumed by influence activities
represent influence costs.
Large vertically integrated firms are
more prone to influence cost problems
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than small independent firms.

Reasons to Make
Costs imposed by poor coordination
Reluctance of partners to develop and
share private information
Transactions cost that can be avoided by
performing the task in-house
Each of the three problems can be traced to
difficulties in contracting

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Contracts
Contracts protect each party to a transaction from
opportunistic behaviour of other(s)
Contracts set out
the set of tasks that need to be performed and
the remedies if one party fails to fulfill its obligation.
Contracts ability to provide this protection depends on
The completeness of contracts
A complete contract stipulates what each party
should do for every possible contingency
No party can exploit others weaknesses
Maps each possible contingency to a set of
stipulated actions & it is enforceable
However, litigation can be time consuming and harm a
business relationship. Laws are open to interpretation.
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Factors that Prevent Complete Contracting

Bounded rationality
Individuals have limited capacity to
process information and deal with complexity
pursue rational aims
foresee possible contingencies
Difficulties in specifying/measuring performance
contract may have some residual vagueness.
Terms like normal wear and tear may have
different interpretations.
Performance cannot be measured unambiguously.
Asymmetric information
Full information is often unavailable to both parties
Knowledge can be misrepresented

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Coordination Problems
Without good coordination, bottlenecks
arise in the vertical chain
To ensure coordination, firms rely on
contracts
Coordination is especially important when
design attributes are present
E.g. Timely delivery of a critical component

Small errors can be extremely costly.

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Leakage of Private Information

Firms do not want to compromise the
source of their competitive advantage .
Private information on product design or
production know-how may be compromised
when outside firms are used in the vertical
chain.
Contracts with non-compete clauses can be
used to protect against leakage of
information, but hard to enforce
Patents may provide (limited) help
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Transactions Costs
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
centralised direction transactions costs
Outsourcing entails costs of negotiating, writing
and enforcing contracts
Costs incurred due to opportunistic behaviour of
parties to the contract and efforts to prevent such
behaviour are transaction costs as well.
Transactions costs explain why economic
activities occur outside the price system (inside
the firm).
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Transactions Costs
Sources of transactions costs
Investments that need to be made in
relationship specific assets
Possible opportunistic behavior after the
investment is made (holdup problem)
Quasi-rents (magnitude of the holdup
problems)

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Asset specificity
Relation-specific assets may exhibit different forms of
specificity:
Site specificity
Physical asset specificity
Dedicated assets
Human asset specificity
Please see Besanko et al Ch. 5 for further details.

Relationship-Specific Assets
Relation-specific assets are assets essential for a
given transaction
These assets cannot be redeployed for another
transaction without cost
Once the asset is in place, the other party to the
contract cannot be replaced without cost, because
the parties are locked into the relationship to some
degree
Once the investment is made the situation
becomes a bargaining situation with a small
number of partners
Relationship specific assets cause a
fundamental transformation in the relationship
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Asset specificity: Examples

Assets may have to be located in close proximity to
economise on transportation costs and inventory
costs, and to improve process efficiency:
Cement factories usually located near lime stone
deposits.
Can-producing plants located near can-filling
plants.
Some of the employees of the firms engaged in the
transaction may have to acquire relationship-specific
skills, know-how and information:
Clerical workers in a physicians office acquire the
skills to use a particular practice management
software.
Salespersons posses detailed knowledge of
customer firms internal organisation.

Rents and Quasi-Rents

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 from an alternate
transaction
Mathematical treatment of quasi-rents
and the hold up problem is not expected.
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The Holdup Problem

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
Underinvestment in these assets
Investment in safeguards
Reduced trust
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The Make-or-Buy Decision Tree

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Lecture summary
We have analysed vertical boundaries of the firm.
We have analysed particular firm strategies arising
out of vertical integration based decisions.
We have considered:
Vertical integration.
Make versus buy decision.
Contracts.
Transaction costs.

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