3 - Vertical boudaries Of The Firm Flashcards
Vertical chain (definition)
The process that begins with the acquisition of raw materials and end with the distribution and sale of finished goods and services
The vertical boundaries of the firm
Define the activities that the firm perform itself as opposed to purchased from independent firms in the market
Decision to perform an activity or purchase
Make-or-buy decision
Make or buy continuum
Less integrated
Arm’s length market transaction Longtemps contract Alliances and JV Subsidies Integrate
More integrated
Vertical foreclosure
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
Reasons to Buy (market firms)
1- Exploiting Scale and Learning Economies
2- Avoiding bureaucracy effects
3- Subject to discipline of the market (efficient+ innovative)
1st reason to buy
Scale and learning economies
- aggregate customers demand
- proprietary information and patent
- exploit experience to obtain learning economies
2nd reason to buy
Avoid bureaucracy effects
- agency costs (motivation)
- influence costs (lobbying for resources)
- organisational design
Agency costs
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.
Influence costs
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
Reasons to make
1- Incompleteness of contracts
2- Coordination of product flows
3- Risk of leakage information
4- Transaction costs
1st reason to make: incompleteness of contracts
- 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.
2nd reason to make
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
4th reason to make
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
Relation specific asset
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
Rent and quasi rent
Rent: forecasted profit assuming all goes as planned
Quasi rent: rent - rent of 2nd best opportunity
Hold-up problem
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
Division in hierarchical firms may
Hide inefficiencies behind complex monitoring and rewards systems
3 reasons why vertical integration may be a good alternative
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
Contract laws
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)
Make or buy fallacies
- 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
