Chapter 3 - the vertical boundaries of the firm Flashcards
vertical chain
the process that begins with the acquisition of raw materials and ends with the distribution and sale of finished goods and services
vertical boundaries
define the activities that the firm itself performs as opposed to purchases from independent firms in the market
make-or-buy decision
firm’s decision to perform an activity itself or to purchase it from an independent firm
make
firm performs the activity itself
buy
firm relies on an independent firm to perform the activity
upstream
early steps in the vertical chain
downstream
later steps in the vertical chain
benefits of using the market
- 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
costs of using the market
- 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
firms should MAKE an asset, if that asset is a source of competitive advantage
an asset that can easily be obtained from the market cannot be a source of competitive advantage, whether the firm makes or buys it
firms should BUY to avoid the costs of making the product
the firm will pay the costs either way; it is not possible to remove the steps from the vertical chain
firms should MAKE to avoid paying a profit margin to independent firms
if the supplier of the input is so profitable, why don’t other firms enter the input market and drive the price down?
firms should MAKE to be able to avoid paying high market prices for the input during periods of peak demand or scarce supply
do not vertically integrate to eliminate income risk
firms should MAKE to tie up a distribution channel
vertical integration cannot increase profits above the monopoly profit –> no reason to foreclose
vertical foreclosure
integration to tie up channels
reasons to buy
- exploiting scale and learning economies
- bureaucracy effects: avoiding agency and influence cost
agency costs
costs associated with shirking and the administrative controls to deter it
shirking
managers/workers who knowingly do not act in the best interest of their firm
influence costs
costs that arise when transactions are organized internally (internal capital markets)
organizational design
organizational design, or hierarchy, defines the lines of reporting and authority within the firm
contracts
define the conditions of exchange (standardized vs specific form)
complete contract
eliminates opportunities for shirking by stipulating each party’s responsibilities and rights for each and every contingency that could conceivably arise during the transaction
three factors that prevent complete contracting
- bounded rationality
- difficulties specifying or measuring performance
- asymmetric information
bounded rationality
limits on capacity of individuals to process information, deal with complexity and pursue rational aims
difficulties specifying or measuring performance
when performance is complex/subtle, not even the most accomplished wordsmiths may be able to spell out each party’s right and responsibilities
asymmetric information
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
reasons to make
- 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
timing fit
marketing campaign must coincide with increased production and distribution
sequence fit
steps in a medical treatment protocol must be properly sequenced
technical specification fit
sunroof of a car must fit precisely into the roof opening
color fit
tops in Benetton’s spring fashion line-up must match the bottoms
merchant coordinators
independent firms that specialize in linking suppliers, manufacturers and retailers
design attributes
attributes that need to relate to each other in a precise fashion, otherwise lose economic value
assignment problem
ensuring that the right people do the right jobs with minimal duplication of effort (easier in central office)
private information
information no one else knows (e.g., production know-how, product design, consumer information, …)
transaction costs
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
relationship-specific assets
supports a given transaction and cannot be redeployed to another transaction without sacrifice in productivity or some additional cost
forms of asset specificity
- site specificity
- physical asset specificity
- dedicated assets
- human asset specificity
site specificity
assets that are located side by side to economize transportation or inventory costs or to take advantage of processing inefficiencies
physical asset specificity
assets whose physical/engineering properties are specifically tailored to a particular transaction
dedicated assets
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
human asset specificity
workers who acquired skills, know-how, information that are more valuable inside a particular relationship than outside it (tangible & intangible)
fundamental transformation
once the parties invest in relationship-specific assets, the relationship changes from a “large numbers” bargaining situation to a “small numbers” bargaining situation
relationship-specific investment (RSI)
the amount of investment that you cannot recover if your company does NOT do business with Ford
rent
the profit you expect to get when you build the plant, assuming all goes as planned
quasi-rent
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
holdup
a firm holds up its trading partner by attempting to renegotiate the terms of a deal
the holdup problem raises the cost of transacting arm’s length market exchanges in four ways
- contract negotiation and renegotiation
- investments to improve ex post bargaining positions
- distrust
- reduced investment
contract negotiation and renegotiation
trading partners anticipate the possibility of holdup in initial contract negotiations (time consuming and costly)
investment to improve ex post bargaining positions
parties that anticipate the possibility of holdup might make investments that improve their post contractual bargaining positions (e.g., standby production, 2nd source, …)
distrust
in the case of a breakdown of the cooperation, the resulting distrust raises the costs of contracting in two ways:
- direct costs of contract negotiation
- impedes sharing information
reduced investment
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
