Ayfer Ali

Lecturer

Strategy Analysis and Practice

Corporate Strategy
 What Is Corporate Strategy?

• Corporate strategy
• Corporate strategy is the way a company creates value through the
configuration and coordination of its multi-market activities

• Three key dimensions:

• What industries (diversification)

• What stages of industry value chain (vertical integration)

• Where in the world to compete (geography)

Vertical boundaries: The value chain

• Which stages of the “value chain” take

place within the firm?

Vertical boundaries
 Vertical boundaries: vertical integration

Production/processing activities

Raw materials acquisition

Support activities
Transportation and
Planning
storage

Intermediate goods Accounting

production
Vertical Human Resource Mgmt
Transportation and
storage
Disintegration
Assembly/ production Financing
of final product
Marketing
Wholesale distribution

…
Retail distribution
 Vertical boundaries: vertical integration

Production/processing activities

Raw materials acquisition

Support activities
Transportation and
Planning
storage

Intermediate goods Accounting

production
Backward Human Resource Mgmt
Transportation and
integration storage

Assembly/ production Financing

of final product
Marketing
Wholesale distribution

…
Retail distribution
 Vertical boundaries: vertical integration

Production/processing activities

Raw materials acquisition

Support activities
Transportation and
Planning
storage

Intermediate goods Accounting

production
Forward Human Resource Mgmt
Transportation and
integration storage

Assembly/ production Financing

of final product
Marketing
Wholesale distribution

…
Retail distribution
Make (backward integrate) or buy (outsource)?

• “Make” = produce inputs to be used within the firm (backward

integrate)
• “Buy”: buy inputs from the market … rather than produce them “in-
house”
• “Make or buy?” = “Backward integrate?”
• Same ideas apply to: “Forward integrate or not?”
Reasons to buy

1. Production efficiency:
• Non-replicable resources
• Knowledge, expertise, relationships, patents
• Economies of scale
• Specialization
• specialized firm can be large - supplying multiple downstream firms so likely achieves
better economies of scale
• Learning economies
• Specialized firm knows more as it produces more
2. Incentives
• Stronger incentives
• Market firms: competition  strong incentives to increase quality / reduce costs
• Reduced influence costs
• Performance measures:
• Influence activities: to influence allocation of resources across divisions
Reasons to make (to backward integrate)

• Contracting and renegotiation costs

• Specific investments, hold up and vertical
integration
• Leakage of sensitive private information
• Coordination in problems with design attributes
 Contracting and renegotiation costs
• Any economic transaction between two market
participants is governed by a contract.
• Contracts specify:
• Characteristics of good or service
• Amount to be delivered
• Timing and mode of delivery
• Amount to be paid, form and timing of payment.
• Penalties for breach of contract,…
Contracting and renegotiation costs

• Simple contracts hard/impossible when

transactions:
• Are complex
• Involve a great deal of uncertainty
• Have long duration (uncertainty ↑)
• Why?
• Terms of the contract not adapted to uncertain circumstances:
• Suboptimal product/service
• Too high cost
• Parties bear too much risk
 Contracting and renegotiation costs
• How to regulate complex/uncertain/long duration market
transactions?
 contingent contracts
• Problems with contingent contracts:
• Costly to write / evaluate performance / enforce complete
contingent contracts
• Costly to renegotiate if contingent contract is left incomplete:
• Direct negotiation costs
• Costly delays
• Inefficiencies due to information asymmetries

* a contingent contract – one that specifies what happens under specific

circumstances (e.g. if there delivery delayed, penalty is £70/day
* a complete contract – one that specifies duties/rights for every contingency (every
possible future state of the world relevant to the contract)
 Contracting and renegotiation costs
• Alternative:
• Do not use the market  carry out the transaction in-house
(vertical integration)
• How does this help?
• With vertical integration, the contract specifying what the
“supplier” (now an employee) has to do can be left very
incomplete ( low contracting costs)
• “Renegotiation” is much easier when one party (the
employer) has the authority (within limits) to tell the other
party (the employee) what to do.
 Contracting and renegotiation costs - RULES
• If there is Little uncertainty / complexity:
• The contracting costs of simple market
transactions are small
• Productive advantages of the market
 no vertical integration
 Contracting and renegotiation costs - RULES
• If there is Great uncertainty / complexity, long
duration of contract term:
 Either (costly) contingent contracting with
renegotiation
 Or vertical integration
• Which option?
• Depends on the costs of contracting and
renegotiation.
• What determines these costs?
• Key factor: asset specificity.
Reasons to make

• Contracting and renegotiation costs

• Specific investments, hold up and vertical
integration
• Leakage of sensitive private information
• Coordination in problems with design
attributes
Specific investments, hold up and vertical integration

Some terminology:
Relationship-specific assets: the value of the asset if it is used
outside of the relationship is lower than if it is used within the
relation

Specific investment: investment in relationship-specific assets

General investment (opposite of specific investment): investment in

assets whose value is not lower outside the relationship
 there exists at least one alternative party for which the asset is at least as valuable
Specific investments, hold up and vertical integration

• Where does the specificity come from?

• Site specificity
• Non-human asset specificity
• Human asset specificity
Specific investments, hold up and vertical integration

• Where does the specificity come from?

• Site specificity
• Non-human asset specificity
• Human asset specificity
Specific investments, hold up and vertical integration

Site specificity
• Stems from geographical proximity
• If:
• Transportation takes time and timing of deliveries is
important, or
• Transportation costs are substantial

 value of an asset will be higher if located in close proximity

• Cement factories are usually located near lime stone
deposits
• Can-producing plants are located near can-filling plants
• Canonical case: oil pipeline
 Specific investments, hold up and vertical integration
Example: oil pipeline Asset: pipeline from O to A
•Value of asset if used to transport oil
from O to A: VA
•Value of asset if used to transport oil
from O to B?

Pipeline •VB minus

Oil field • cost of dismantling the pipeline

Refinery A • cost of transporting the pieces
• cost of new pieces needed

O • costs of assembling the new pipeline

Refinery B
Specific investments, hold up and vertical integration

• Where does the specificity come from?

• Site specificity
• Non-human asset specificity
• Human asset specificity
Specific investments, hold up and vertical integration

Non-human Asset Specificity

• Non-human assets may be designed specifically for the
particular transaction:
• Physical assets:
• Machines: precision machines for the production of a specific
electronic component
• Buildings: specially-shaped buildings/interiors (airplane hangar)
• ...
• “Knowledge assets”:
• Software application specific to a particular application-firm
• Designs, blueprints (engineering, fashion,...)
Specific investments, hold up and vertical integration

• Where does the specificity come from?

• Site specificity
• Non-human asset specificity
• Human asset specificity
Specific investments, hold up and vertical integration

Human asset specificity

• Employees of firms engaged in the transaction may acquire
relationship-specific skills, know-how, information
• Clerical workers at WBS acquire skills to use particular
software applications (library catalog, HR
management, ...)
• Employees of service provider in outsourcing relationship
acquire detailed knowledge of client firm’s internal
organization
 Asset specificity, rents and quasi-rents
• Specific investment → “fundamental transformation” changes context in
which transaction takes place

Before specific After specific

investment investment

Transaction can
be carried out SPECIFIC “Bilateral
with many INVESTMENT monopoly”
similar parties

Many parties One party

 Asset specificity, incomplete contracts and renegotiation
• If not possible to determine by contract the exact
configuration/quality/delivery schedule and price of the
good produced with the specific asset (incomplete
contract)
• the final design/quality of the good may not be completely
known in advance
• the production costs are uncertain
• the demand for the good produced using the input is
uncertain
• the delivery schedules are uncertain…
 After investment is made and uncertainty is resolved:
renegotiation (price, quality, delivery conditions)
• direct costs
• opportunity costs (delay, potentially inefficient
outcome)
Asset specificity and the hold-up problem

• If an asset has lower value outside of a relationship one party may

be able to “hold up” the other
• hold up: “rob at gunpoint or by means of some other threat”
• In our case: threat = termination of the relationship (which would
force party who made specific investment to use assets in activity
that generates less value)
 Asset specificity and vertical integration
• If a party predicts that it may be “held up” after making a
specific investment:
• specific investment may not be made to begin with (or at
an inefficiently low scale)
and/or
• initial negotiations may be long/difficult to ensure no
hold up ex post
and/or
• the party may make inefficient investments with the goal
of improving bargaining position/prevent hold up

 vertical integration may be a solution

 Optimal Input Procurement

No Spot Exchange
Substantial
specialized
investments
relative to Yes Complex contracting
contracting costs? environment relative to
costs of integration?

No Yes

Vertical
Contract Integration

Managerial Eco. - Rutgers University 6-13

Reasons to make

• Contracting and renegotiation costs

• Specific investments, hold up and vertical
integration
• Leakage of sensitive private information
• Coordination in problems with design
attributes
Leakage of Private Information

• Having an external firm produce an input often involves

sharing information with the supplier firm
• The characteristics of the input may require the client firm to
share critical/sensitive information with the supplier
• Critical information: information that provides the firm its
competitive advantage (not easily replicable)
• Information sharing with supplier may lead to leakage of
critical information:
• Less secure communication
• Less secure data transmission (e-mails, pen-drives,… outside of
company’s firewall)
• Supplier may use or sell sensitive information
Leakage of Private Information

Solutions:
• Contracts to protect against leakage of critical information:
• Patents
• Trademarks
• Exclusivity clauses
• Vertical integration: If difficult to protect critical information if input
procured from the market  vertical integration may be solution
• More secure communication
• Easier monitoring
• An individual employee may have fewer possibilities to trade on
sensitive information
• Non-compete clauses for employees
Reasons to make

• Contracting and renegotiation costs

• Specific investments, hold up and vertical
integration
• Leakage of sensitive private information
• Coordination in problems with design
attributes
Coordination in problems with design attributes

• Generally, the success of an activity depends on how other activities

are carried out
• Success requires coordination of the parties carrying out the
different activities to achieve the right fit
• Examples:
• Timing fit: movie release and marketing need to be coordinated
• Size fit: the sizes of the different components of an Ikea dresser need to match tightly; the
different components of a car need to fit together
• Sequence fit: the sequencing of courses in a degree needs to be coordinated so that
students have the right knowledge at each stage
 Example: Boeing 787 Airliner
• “The next-generation airliner is billions of dollars over budget and about three years late; the
first paying passengers won't be boarding until this fall, if then.
• … [M]uch of the blame belongs to the company's quantum leap in farming out the design
and manufacture of crucial components to suppliers around the nation and in foreign
countries such as Italy, Sweden, China, and South Korea.
• Boeing's goal, it seems, was to convert its storied aircraft factory near Seattle to a mere
assembly plant, bolting together modules designed and produced elsewhere as though from
kits.
• The drawbacks of this approach emerged early.
• Some of the pieces manufactured by far-flung suppliers didn't fit together.
• Some subcontractors couldn't meet their output quotas, creating huge production logjams
when critical parts weren't available in the necessary sequence.
• Rather than follow its old model of providing parts subcontractors with detailed blueprints
created at home, Boeing gave suppliers less detailed specifications and required them to
create their own blueprints.”
The Los Angeles Times, February 15, 2011.
Reasons to forward integrate

• Access to market information

• Control of brand
Some Make-or-Buy Fallacies

• “By outsourcing an activity, we will eliminate the cost of that activity,

and thereby increase earnings.”

• “Our firm should backward integrate to capture the profit of our

suppliers for ourselves.”

• “By vertically integrating, we obtain the input at cost, thereby

insuring ourselves against the risk of high input prices.”