Firm Boundaries Flashcards
What are the boundaries of a firm?
The scope of the firm.
What two types of dimensions can you divide the boundaries into?
Vertical (Value chain): Specialization (different companies over the value chain) vs. integration (1 company over the entire value chain)
Horizontal: Could be different products/geographical areas
In a vertically scoped company, what does the two possibilities look like?
1) Single integrated firm across the entire value chain
2) Several Specialized Firms across the value chain
Horizontal boundaries in a company can look like what?
1) Product scope (P1, P2, P3)
2) Geographical scope (G1, G2, G3)
Daughter businesses built on products or differences in geography
What are the benefits of vertical integration?
1) Technical economies from physical integration of processes
2) Avoid profit capture by powerful suppliers (demanding high prices) and distributors (insisting on lower purchase prices)
3) Avoiding search, contracting, monitoring and enforcement costs
4) Avoiding dependencies arising from relationship-specific investments - like hold-ups
What are the costs of vertical integration?
1) Units may not achieve sufficient scale to produce efficiently
2) Managing structurally different business is difficult
3) Specialization may allow for better development of unique capabilities
4) Incentive problems: vertical units may not remain competitive
5) Negative competitive effects: competing with customers
What drives the choice for vertical integration?
The “make-or-buy” decision (which translates into integration, alliances, licensing, etc.) is strongly driven by considerations of transaction costs
- Search costs: finding the right partners
- Contracting costs: specifying the required parameters of a transaction (e.g. quality)
- Monitoring and enforcement costs: monitoring partner’s compliance
- Asset specificity: collaboration implies investment into relationship-specific assets, which might be exploited by partner (opportunistic behavior)
What are vertical boundary hold-ups?
Hold-up: an action to exploit another party’s dependence
- Arises from relationship-specific investments: an asset is only useful in the context of the collaboration («sunk costs»)
- One party imposes new, for the partner unfavorable, terms (like price increases) – now you can either find a new partner or go along with lower profits
How can you avoid a hold-up?
- Solution if specific investments cannot be avoided: detailed contracts or vertical integration
- Both solutions are costly
- Contracts may not be enforceable
Examples of vertical boundary hold-ups are?
Buildings, metro etc. – “this will cost 5 billion USD”, not they come and say that they ran out of money and need another billion to finish the metro. Do you sink this cost or add the next billion?
Describe a vertical boundary concept in Biotech/Pharma
Vertical boundaries – Big pharma buys smaller biotechs licenses to produce their drug/R&D or buys small biotechs for their drug.
When did large R&D companies form?
In the industrialization due to the fact that “inventors” couldn’t do it alone anymore. You needed larger R&D corporations to innovate.
What are some motives for horizontal integration without diversification?
- Seeking ownership or increasing control over a firm’s competitors through M&A’s among competitors
- Economics of scale through size increase
- Increasing market power (but anti-trust may limit possibilities)
How can you horizontally expand?
Diversification strategy
- Extended product scope (related & unrelated diversification)
Geographic expansion
M&A
What are motives of horizontal diversification?
- Accessing new growth opportunities
- Diversifying business risks
- Economies of scope (makes the simultaneous manufacturing of different products more cost-effective than manufacturing them on their own)
- Internal capital and labor markets
- Economies from internalizing transactions
