Economics of Strategy

Seventh Edition
Besanko, Dranove, Shanley and Schaefer

Chapter 3

The Vertical Boundaries of the Firm

Copyright  2016 John Wiley  Sons, Inc.

 The Vertical Chain

The vertical chain

 begins with the acquisition of raw materials
and,
 ends with the sale of finished goods/services.

Organizing the vertical chain is an

important part of business strategy
 Vertical Boundaries of the Firm

Vertical boundaries of the firm determine which

tasks are to be performed inside the firm and
which to be out-sourced.
The choice between the using the market or
using the organization 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

 Upstream, Downstream

Early steps in the production process are

upstream (Timber for furniture) i.e., factors
Later steps are downstream (finished goods in
showrooms) i.e., sales
Support services are provided all along the chain
Vertical Chain of Production
 Defining Boundaries

Firms need to define their vertical boundaries.

Outside specialists who can perform vertical
chain tasks are market firms.
Market firms are often recognized leaders in
their field (Example: UPS).
 Market Firms

Benefits of using market firms

 Economies of scale achieved by market firms
 Value of market discipline

Disadvantages of using market firms

 Problems in coordination of production flows
 Possible leak of private information
 Transactions costs
 Some Make-or-Buy Fallacies

Firm should make rather than buy assets that provide

competitive advantages
Outsourcing an activity reduces 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
 Vertical Integration & Input Price Risk

Instead of vertical integration, long term

contracts can be used to reduce input price risk
Forward or futures contracts can also be used to
hedge input price risk
Alternately the capital tied up in vertical
integration could be used as a contingency fund
to deal with price fluctuations.
 Foreclosure of Distribution Channels

Acquiring a downstream monopoly supplier

may seem to be a way to tie up channels and
increase profits
Three possible limitations
 Possible violation of anti trust laws
 Price paid for the downstream firm may reflect the
full value of the monopoly power
 Competitors may be able to open new distribution
channels
 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
 Economies of Scale
Production Costs and the Make-or-Buy Decision
 Economies of Scale

A given manufacturer of automobiles needs A’

units
An outside supplier may reach the minimum
efficient scale (A*) by supplying to different
automobile manufacturers
The cost is lowered by using the outside supplier
 Economies of Scale (cont.)

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 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.
It is difficult to internally replicate the incentives
faced by market firms
 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.
 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
 Role of Contracts

Firms often use contracts when certain

tasks are performed outside the firm.
Contracts list:
 the set of tasks that need to be performed,
 the remedies if one party fails to fulfill its
obligation and,
 the cost to perform the tasks
 Complete Contracts

Contracts protect each party to a

transaction from the opportunistic behavior
of the other party
Contracts provide this protection by
 the “completeness” of the contract
 the body of contract law
 Incomplete Contracts

Incomplete contracts involve some ambiguities

They do not anticipate all possible contingencies
They do not spell out rights and responsibilities
of parties completely
 Factors that Prevent Complete Contracting

Bounded rationality
Difficulties in specifying/measuring
performance
Asymmetric information
 Bounded Rationality

Individuals have limited capacity to

 process information
 deal with complexity

 pursue rational aims

Individuals cannot foresee all possible

contingencies
 Specifying/Measuring Performance

What constitutes fulfillment of a contract may

have some residual vagueness.
Terms like “normal wear and tear” may have
different interpretations.
Performance cannot always be measured
unambiguously.
 Asymmetric Information

Parties to the contract may not have equal access

to contract-relevant information.
The knowledgeable party can misrepresent
information with impunity.
Contracting on items that rely on this
information is difficult.
 Contract Law

Contract law facilitates transactions when

contracts are incomplete.
Parties need not specify provisions that are
common to a wide class of transactions.
In the U. S. contract law is embodied in
common law and the Uniform Commercial
Code.
 Limitations of Contract Law

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
 Litigation can be time consuming
 Litigation weakens the business relationship
 Coordination of Production Flows

Firms make decisions that depend in part on the

decisions made by other firms along the vertical
chain.
A good fit will have to be accomplished in all
dimensions of production. (Examples: Timing,
Size, Color and Sequence)
 Coordination Problems

Without good coordination, bottlenecks arise in

the vertical chain
To ensure coordination, firms rely on contracts
Firms also use merchant coordinators –
independent specialists who work with firms
along the vertical chain
 Coordination Problems

Coordination is especially important when

design attributes are present
Design attributes are attributes that need to
relate to each other in a precise fashion. Some
examples are:
 Fitof auto sunroof glass to opening
 Timely delivery of a critical component

Small errors can be extremely costly.

 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.
 Leakage of Private Information

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

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
Outsourcing entails costs of negotiating, writing
and enforcing contracts
 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)
 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
 Forms of Asset Specificity

Relation-specific assets may exhibit

different forms of specificity
 Sitespecificity
 Physical asset specificity

 Dedicated assets

 Human asset specificity

 Site Specificity

Assets may have to be located in close

proximity to economize on transportation costs
and inventory costs and to improve process
efficiency
 Cement factories are usually located near lime stone
deposits
 Can-producing plants are located near can-filling
plants
 Physical Asset Specificity

Physical assets may have to be designed

specifically for the particular transaction
 Molds for glass container production custom made for
a particular user
 A refinery designed to process a particular grade of
bauxite ore
 Dedicated Assets

Some investments are made to satisfy a single

buyer, without whose business the investment will
not be profitable.
 Ports investing in assets to meet the special needs of
some customers
 A defense contractor’s investment in manufacturing
facility for making certain advanced weapon systems
 Human Asset Specificity

Some of the employees of the firms engaged in the

transaction may have to acquire relationship-
specific skills, know-how and information
 Clerical workers acquire the skills to use a particular
enterprise resource planning software
 Salespersons posses detailed knowledge of customer
firm’s internal organization
 Rents and Quasi-Rents

The term rent denotes economic profits –

economic profits are the remainder after all
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
 Rents and Quasi-Rents

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 B were to renege on the agreement and A is
forced to sell its output in the open market, the
economic profit will be π2
 Rents and Quasi-Rents

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

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
“holdup.”
With incomplete contracts and relationship-
specific assets, quasi-rent may exist and lead to
the holdup problem
 Holdup Effect on Transactions Costs

The holdup problem raises the cost of transacting

exchanges
 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 relationship

specific assets
 Holdup and Costly Safeguards

Potential for holdup may lead parties to invest in

wasteful protective measures
 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
 The Holdup Problem: Summary

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
The Make-or-Buy Decision Tree
 Copyright © 2016 John Wiley & Sons, Inc.

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