3 - Vertical boudaries Of The Firm

Question 1

Vertical chain (definition)

Answer 1

The process that begins with the acquisition of raw materials and end with the distribution and sale of finished goods and services

Question 2

The vertical boundaries of the firm

Answer 2

Define the activities that the firm perform itself as opposed to purchased from independent firms in the market

Question 3

Decision to perform an activity or purchase

Answer 3

Make-or-buy decision

Question 4

Make or buy continuum

Answer 4

Less integrated

Arm’s length market transaction
Longtemps contract
Alliances and JV
Subsidies
Integrate 

More integrated

Question 5

Vertical foreclosure

Answer 5

Integration to tie up channels. 4 scenarios with upstream/downstream terminology + monopoly/competitive firm.
Chicago argument: the motivation for foreclosure cannot be the desire to extent market power since there is a single final product and thus a single monopoly profit. But it allows monopolists to protect their profits.

2 danger:

• competitors may open new channels
• steep fee to acquire a monopolist

Question 6

Reasons to Buy (market firms)

Answer 6

1- Exploiting Scale and Learning Economies
2- Avoiding bureaucracy effects
3- Subject to discipline of the market (efficient+ innovative)

Question 7

1st reason to buy

Answer 7

Scale and learning economies

• aggregate customers demand
• proprietary information and patent
• exploit experience to obtain learning economies

Question 8

2nd reason to buy

Answer 8

Avoid bureaucracy effects

• agency costs (motivation)
• influence costs (lobbying for resources)
• organisational design

Question 9

Agency costs

Answer 9

Are associated costs that occur when employees of a company make decisions which do not contribute to the firm’s success and need to be deterred by administrative controls.

Question 10

Influence costs

Answer 10

Lobbying for internal resources. The lack of objective information ultimately results in an inefficient allocation of internal capital in vertically integrated firms.

To limit lobbying:
- loosen the connection between a business unit profitability and manager compensation

Question 11

Reasons to make

Answer 11

1- Incompleteness of contracts
2- Coordination of product flows
3- Risk of leakage information
4- Transaction costs

Question 13

1st reason to make: incompleteness of contracts

Answer 13

• should be enforceable
• complete
  1) agree on satisfactory performance and measure it
  2) contemplate all relevant contingencies

Incomplete contracts (ambiguous)

1) bounded rationality
2) difficulties in specifying or measuring performance
3) asymmetric information.

Question 14

2nd reason to make

Answer 14

1)Coordination of production flows

Design attributes need to seamlessly fit or relate to each other in a precise fashion, otherwise they will lose a major portion of their economic value.

1- timing fit ( timely delivery of part necessary for manufacturing process to begin)
2- sequence fit (sequencing of courses in MBA)
3- technical specification (auto rooftop)
4- color fit (matching color of ensembles)

2) assignment problem

Question 15

4th reason to make

Answer 15

Transaction costs: include the time and expense of negotiating, writing and enforcing contracts.

1- relation specific assets
2- rent and quasi-rent
3- hold up problem

Question 16

Relation specific asset

Answer 16

Support a given transaction and cannot be redeployed to another transaction without some sacrifice in productivity or some additional costs

Site specific: location
Physical asset specificity: physical properties (customisation)
A dedicated asset: investment in plant equipment prior to contract
Human asset specificity

After making relation specific investments, companies will have few alternative trading partners which is called a fundamental transformation by Williamson

Question 17

Rent and quasi rent

Answer 17

Rent: forecasted profit assuming all goes as planned

Quasi rent: rent - rent of 2nd best opportunity

Question 18

Hold-up problem

Answer 18

A supplier has already sunk costs into relation-specific asset and rationally is willing to accept any price between the initial agreed price and the one it could get from the second best alternative. => contract renegociation

Increase transaction price because

• négociation and renégociation are longer and more frequent ( delays, cost, disruption)
• distrust (less shared information)
• over investment
• reduce ex ante investment or post cooperation lowering productivity

Question 19

Division in hierarchical firms may

Answer 19

Hide inefficiencies behind complex monitoring and rewards systems

Question 20

3 reasons why vertical integration may be a good alternative

Answer 20

1) governance arrangements that provide more powerful dispute resolution and greater flexibility ton adapting to changing circumstances
2) introduce a “repeated relationship” that reduces uncertainty and makes relation-specific investment more profitable
3) Allow organisational culture to promote an atmosphere of cooperation

Question 21

Contract laws

Answer 21

Specify a set of standard provisions applicable to wide classes of transactions and eliminate the need for parties to specify these provisions in every single transaction.

Limits:

• broad language
• costly (litigation)

Question 22

Make or buy fallacies

Answer 22

• buy to avoid the cost of making the product
• make if it is a source of CA, whatever is cheaper and CA cannot be bought
• make to avoid paying a profit margin
• make to avoid high market price
• make to tie up distribution channel