Chapter 3 - the vertical boundaries of the firm

Question 1

vertical chain

Answer 1

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

Question 2

vertical boundaries

Answer 2

define the activities that the firm itself performs as opposed to purchases from independent firms in the market

Question 3

make-or-buy decision

Answer 3

firm’s decision to perform an activity itself or to purchase it from an independent firm

Question 4

make

Answer 4

firm performs the activity itself

Question 5

buy

Answer 5

firm relies on an independent firm to perform the activity

Question 6

upstream

Answer 6

early steps in the vertical chain

Question 7

downstream

Answer 7

later steps in the vertical chain

Question 8

benefits of using the market

Answer 8

• market firms can achieve economies of scale that in-house departments producing only for their own needs cannot
• market firms are subject tp the discipline of the market and must be efficient and innovative to survive. overall corporate success may hide the inefficiencies and lack of innovativeness of in-house departments

Question 9

costs of using the market

Answer 9

• coordination of production flows through the vertical chain may be comprised when an activity is purchased from an independent market firm rather than performed in-house
• private information may be leaked when an activity is performed by an independent market firm
• there may be costs of transacting with independent market firms that can be avoided by performing the activity in-house

Question 10

firms should MAKE an asset, if that asset is a source of competitive advantage

Answer 10

an asset that can easily be obtained from the market cannot be a source of competitive advantage, whether the firm makes or buys it

Question 11

firms should BUY to avoid the costs of making the product

Answer 11

the firm will pay the costs either way; it is not possible to remove the steps from the vertical chain

Question 12

firms should MAKE to avoid paying a profit margin to independent firms

Answer 12

if the supplier of the input is so profitable, why don’t other firms enter the input market and drive the price down?

Question 13

firms should MAKE to be able to avoid paying high market prices for the input during periods of peak demand or scarce supply

Answer 13

do not vertically integrate to eliminate income risk

Question 14

firms should MAKE to tie up a distribution channel

Answer 14

vertical integration cannot increase profits above the monopoly profit –> no reason to foreclose

Question 15

vertical foreclosure

Answer 15

integration to tie up channels

Question 16

reasons to buy

Answer 16

• exploiting scale and learning economies

- bureaucracy effects: avoiding agency and influence cost

Question 17

agency costs

Answer 17

costs associated with shirking and the administrative controls to deter it

Question 18

shirking

Answer 18

managers/workers who knowingly do not act in the best interest of their firm

Question 19

influence costs

Answer 19

costs that arise when transactions are organized internally (internal capital markets)

Question 20

organizational design

Answer 20

organizational design, or hierarchy, defines the lines of reporting and authority within the firm

Question 21

contracts

Answer 21

define the conditions of exchange (standardized vs specific form)

Question 22

complete contract

Answer 22

eliminates opportunities for shirking by stipulating each party’s responsibilities and rights for each and every contingency that could conceivably arise during the transaction

Question 23

three factors that prevent complete contracting

Answer 23

• bounded rationality
• difficulties specifying or measuring performance
• asymmetric information

Question 24

bounded rationality

Answer 24

limits on capacity of individuals to process information, deal with complexity and pursue rational aims

Question 25

difficulties specifying or measuring performance

Answer 25

when performance is complex/subtle, not even the most accomplished wordsmiths may be able to spell out each party’s right and responsibilities

Question 26

asymmetric information

Answer 26

even if parties can foresee all contingencies and specify and measure relevant performance dimensions, a contract may still be incomplete because the parties do not have equal access to all contract-relevant information

Question 27

reasons to make

Answer 27

• costly and difficult to write and enforce efficient contracts
• coordination of production flows through the vertical chain
• prevent leakage of private information
• eliminate transaction costs

Question 28

timing fit

Answer 28

marketing campaign must coincide with increased production and distribution

Question 29

sequence fit

Answer 29

steps in a medical treatment protocol must be properly sequenced

Question 30

technical specification fit

Answer 30

sunroof of a car must fit precisely into the roof opening

Question 31

color fit

Answer 31

tops in Benetton’s spring fashion line-up must match the bottoms

Question 32

merchant coordinators

Answer 32

independent firms that specialize in linking suppliers, manufacturers and retailers

Question 33

design attributes

Answer 33

attributes that need to relate to each other in a precise fashion, otherwise lose economic value

Question 34

assignment problem

Answer 34

ensuring that the right people do the right jobs with minimal duplication of effort (easier in central office)

Question 35

private information

Answer 35

information no one else knows (e.g., production know-how, product design, consumer information, …)

Question 36

transaction costs

Answer 36

costs using the market that can be eliminated by using the firm

• time and expense of negotiating, writing, enforcing contracts
• potential costs that arise when firms exploit incomplete contracts opportunistically

Question 37

relationship-specific assets

Answer 37

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

Question 38

forms of asset specificity

Answer 38

• site specificity
• physical asset specificity
• dedicated assets
• human asset specificity

Question 39

site specificity

Answer 39

assets that are located side by side to economize transportation or inventory costs or to take advantage of processing inefficiencies

Question 40

physical asset specificity

Answer 40

assets whose physical/engineering properties are specifically tailored to a particular transaction

Question 41

dedicated assets

Answer 41

an investment in plant and equipment made to satisfy a particular buyer. without the promise of that buyer’s business, the investment would not be profitable

Question 42

human asset specificity

Answer 42

workers who acquired skills, know-how, information that are more valuable inside a particular relationship than outside it (tangible & intangible)

Question 43

fundamental transformation

Answer 43

once the parties invest in relationship-specific assets, the relationship changes from a “large numbers” bargaining situation to a “small numbers” bargaining situation

Question 44

relationship-specific investment (RSI)

Answer 44

the amount of investment that you cannot recover if your company does NOT do business with Ford

Question 45

rent

Answer 45

the profit you expect to get when you build the plant, assuming all goes as planned

Question 46

quasi-rent

Answer 46

the EXTRA profit that you get if the deal goes ahead as planned versus the profit you would get if you had to turn to your next-best alternative

Question 47

holdup

Answer 47

a firm holds up its trading partner by attempting to renegotiate the terms of a deal

Question 48

the holdup problem raises the cost of transacting arm’s length market exchanges in four ways

Answer 48

• contract negotiation and renegotiation
• investments to improve ex post bargaining positions
• distrust
• reduced investment

Question 49

contract negotiation and renegotiation

Answer 49

trading partners anticipate the possibility of holdup in initial contract negotiations (time consuming and costly)

Question 50

investment to improve ex post bargaining positions

Answer 50

parties that anticipate the possibility of holdup might make investments that improve their post contractual bargaining positions (e.g., standby production, 2nd source, …)

Question 51

distrust

Answer 51

in the case of a breakdown of the cooperation, the resulting distrust raises the costs of contracting in two ways:

1. direct costs of contract negotiation
2. impedes sharing information

Question 52

reduced investment

Answer 52

the holdup problem can reduce ex ante incentives to invest in specific assets. tendency to underinvest n relationship-specific assets causes problems because they allow firms to achieve efficiencies they cannot achieve with general-purpose investments