L10 - Strategic alliances, Vertical mergers and acquisitions

Question 1

What is an alliance?

Answer 1

• Alliance - ‘organizational structure to govern an incomplete contract between separate firms and in which each firm has limited control’

Question 2

What is an incomplete contact?

Answer 2

• Incomplete contract - does not specify every duty

and every responsibility of the parties under every conceivable circumstance.

Question 3

What is a strategic alliance?

Answer 3

• A strategic alliance is an incomplete contract, involving an agreement to cooperate, that is brokered without the parties being able to foresee at the outset every detail of how their relationship will subsequently evolve
• Needs to be approved by competition authorities

Question 4

How is merger related to incomplete contracts?

Answer 4

• Incomplete contracts tend to leave both parties vulnerable to the possibility of opportunistic behaviour from the other party - merger represents one possible solution to this problem.
• Motives are the same as for mergers (… and cartels)

Question 5

What factors need to be in place for an alliance to be a viable alternative to a merger?

Answer 5

In case of strategic alliance - partners anticipate that the long-run gains of a loose and flexible arrangement outweigh the costs arising from possible opportunistic behaviour in the short run

An efficient alliance must be less costly than merger and must generate positive synergies

Positive synergies arise when the total value of the capabilities of the partners within the alliance is greater than when these capabilities were employed independently.

Question 6

Three synergies of alliances

Answer 6

Modular synergies - derived from resources that are managed independently, but giving value when they are pooled to a solution

Sequential synergies - tasks which, when completed, are forwarded to partners to add further value

Reciprocal synergies - arising through continuous adjustment of resources

Question 7

Fundamental difference between mergers and alliances

Answer 7

Mergers driven by market prices are competitive, and risky in the sense that once a merger has been completed it may be either irreversible or at least difficult and expensive for the two entities to subsequently decouple.

Alliances are typically negotiated, cooperative in nature, and less risky because it is straightforward to terminate the agreement and for the parties to go their separate ways. Alliances can be formed in many different guises, determined by the objectives of the agreement, the control of assets and the managerial structure.

An alliance might be formed between firms with similar capabilities, or it might seek to combine the technological skills of one firm with the marketing skills of another. Alliances can be either horizontal or vertical

Question 8

What are 5 different types of alliances?

Answer 8

Weakest form of alliance - licensing agreement
A licence is a contractual right which gives permission for one party to use an activity or property owned by another. With intellectual property rights such as software, the owner or ‘licensor’ charges a fee to the user or ‘licensee’.

Collaborative alliances include agreements over projects such as research and development programmes.

Equity alliances involve some degree of common or cross-ownership of resources.

Partial acquisition - one partner holds a minority stake in the equity of another; and under partial cross-ownership each partner holds equity in the other.

Joint ventures include agreements between partners to create a new entity to exploit a business opportunity, or to form a consortium to buy a company that will fill a gap in their joint competences.

Question 9

What is upstream, downstream vertical integration and balanced vertical integration respectively?

Answer 9

Upstream (or backward) vertical integration refers to a situation where a firm gains control over the production of inputs necessary for its own operation

Downstream (or forward) vertical integration refers to a situation where a firm gains control over an activity that utilises its outputs

Balanced vertical integration occurs if capacities at successive stages are equal

Question 10

What is an alternative to vertical integration?

Answer 10

Some firms may decide to develop vertical relationships of a looser nature than full-scale vertical integration. Advantages include the preservation of some (or all) of both parties’ independence, and the avoidance of costs that might be associated with vertical integration.

E.g. franchises

Question 11

What is the problem of double marginalisation?

Answer 11

The problem of double marginalisation - arises when the production stage is under the monopoly control of a single producer, the retail stage is under the monopoly control of a single retailer, and both the producer and the retailer add their own markups to the price.

Price is higher and output is lower than when the two stages are vertically integrated

Question 12

What are four combinations of monopoly and competition in double marginalisation?

Answer 12

When both retailers and producers are competitive, P = MC, producer surplus = 0

Monopoly retailer and competitive producer: producers sell at P = MC, retailer sets MR = MC. Producers earn zero abnormal profit, retailers earn abnormal profit. There is deadweight loss. No gain for the retailer to integrate vertically with
(upstream) suppliers - Suppliers produce already at efficient level. Retailer gets abnormal monopoly
in downstream stage, vertical merger would yield no improvement over this

Monopoly producer, competitive retailer: retailers will trade at P = MC, the monopoly producer knows the price it sets will become the retailers’ marginal cost function, hence the market demand facing retailers is also producers demand. Producer sets MR = MC. Monopoly producers earn abnormal profit, retailers do not. Does not make sense for any of the parties to integrate as monopolist producer knows that the price she sets
will become the retailers MC curve - Retailer no abnormal profit, Producer gets abnormal profits in production stage

The case of double marginalisation: monopoly producer knows the price it sets will be the monopoly retailer’s marginal cost and that retailer will set MC = MR. Hence, retailers MR function represents producers demand function. Producer sets MR = MC. Both earn abnormal profit; however, retailer earns larger. Larger deadweight loss. Higher overall profit.

Question 13

What happens when there is forward integration with input substitution?

Answer 13

By integrating with supplier A, producer of X can get input A at MC as well and does not have to pay the mark-up!

This means can use input substitution to go from point D to E: buy more of A cheaper and therefore reduce input B

The result is that X producer can achieve the same output of X at a lower cost!

C3

Question 14

How can price discriminaiton be a market power motive for vertical integration?

Answer 14

Vertical integration could provide a means for implementing a policy of price discrimination, which might otherwise be ineffective or ruled unlawful by the competition authorities.

VI can make price discrimination easier to implement for the monopolist by making sure that downstream firms do not sell your input with each other bypassing you

Three conditions are required for successful price discrimination. First, the supplier must exercise
monopoly control over the market. Second, the price elasticities of demand must be different for different classes of buyer. Third, the supplier must ensure that no resale or seepage occurs

Question 15

What is the transaction cost approach?

Answer 15

Vertical integration may enable the integrated firm to reduce transaction costs

Incentives: The company avoids direct costs of using the market such costly negotiations
o Monitoring the market
o Negotiation costs.
o Search costs, finding the right dealer
o Implement contractual obligations
o File lawsuits (costly) if necessary, to complete transactions

If TC in market are high, vertical integration might be the better option rather than buying inputs/services on the market

Controls: The management is easier by internal control over intra-firm operations as opposed to inter-firm activities. Conflicts are cheaper to solve internally than across suppliers or customers

“Structural advantages“: firm has some comparative advantages relative to the market. Williamson focuses here on the quality of ‘communication’ experience ‘code of conduct’ - this is easier to achieve in an integrated company

Question 16

How can technological conditions be a motive for vertical integration?

Answer 16

Where there are closely related or technologically complementary production process, vertically integrated firm may be able to achieve better planning and coordination, longer production runs and better use of capacity

In many cases, however, this justification for vertical integration does not lead to vertical merger because, if such obvious technological advantages exist, it is likely that integrated plants have been built from the outset.

However, technological change may create new opportunities for integration.

Question 17

When could uncertainty lead to vertical integration?

Answer 17

VI can eliminate uncertainty from both upstream or downstream operation › lower uncertainty = lower cost (it is better to know for sure what will happen)

Vertical integration may be preferable due to

o Uncertainty regarding inputs quality (upstream)

o Uncertainty regarding the aggregate conditions like business cycle: with VI it is easier to ensure a smooth supply of inputs

o Uncertainty regarding customers’ efficiency, such as sales efforts (downstream)

Conversely, companies that have expertise in risk management might prefer to purchase inputs on the market (for them TC lower on market, so less likely to do VI)

Possibly combining own production input with purchase of corresponding input (this is also pressure the market for input)

Question 18

When might vertical integration not be the best response to uncertainty?

Answer 18

Uncertainty need not always lead to vertical integration. In an industry characterised by rapid technological change, a firm might be able to manage risk and uncertainty most effectively by buying in its inputs, rather than producing them itself.

When there is (fluctuating) limited capacity within firm. Can do a quasi-integration, using its own limited capacity in the input stage and buy the rest of the input from market - uncertainty in the company’s ‘internal’ market can cause outsourcing of parts of production to put the risk on other companies

Question 19

How can assured supply be a motive for vertical integration?

Answer 19

An optimal partial integration strategy - integrating to meet high-probability demand, while leaving low-probability demand to specialist producers.

Consider a downstream firm whose demand for inputs varies randomly (can integrate vertically and produce its own inputs, or buy them through the market). If the vertically integrated firm invests in the capacity required to meet demand for inputs in good times, it incurs costs because it has spare capacity in bad times. However, when the downstream firm produces its own inputs, the market demand for inputs falls, leading to a reduction in input prices. This price effect may outweigh the costs of maintaining spare capacity.

The higher the level of investment undertaken by engineering firms in the production of components, the greater the tendency towards vertical integration. Buyers of technologically complex and
strategically important inputs can find themselves at the mercy of suppliers

When producers are more technology intensive than their suppliers, it is more likely that the producer will integrate backward than when the opposite is the case. The implication is that interruptions to the supply of inputs could threaten the producer’s investment

Question 20

How might vertical integration by linked to the industry life cycle?

Answer 20

Vertical integration may be linked to the industry life cycle - In the introduction and growth stages, producers may integrate backward to develop their
own supplies and integrate forward to ensure efficient marketing and aftersales service. As the industry approaches the maturity stage, specialist supply industries and independent distribution channels evolve, allowing producers to divest themselves of upstream and downstream activities. Eventually, during the maturity and decline stages, the extent of vertical integration may increase, as incumbent firms attempt to compensate for declining consumer demand by increasing their market power.

Question 21

What are externalities and how are they linked to vertical integration?

Answer 21

May arise when property rights are poorly defined

E.g. if firm is not able to produce something themselves, incentive to integrate with producer so producer does not share secret

Some producers argue that forward integration into distribution is necessary to protect their investments.

Question 22

How can complexity be a motive for vertical integration?

Answer 22

When two successive stages of a production process are linked by potentially complex legal relations, it may be efficient to integrate vertically

If the product is non-standard it may be difficult to specify an exhaustive contract capable of foreseeing all possible circumstances or pre-empting all possible ambiguities that could subsequently result in expensive litigation. An alternative approach might be to negotiate only a short-term contract. However, where a long-term investment is involved, the producer might feel it requires long-term guarantees - vertical integration
may provide a better solution.

Question 23

How can asset specifity be a motive for vertical integration?

Answer 23

Occurs when two firms are dependent on each other, as a result of investments in specific physical capital, human capital etc.

The specialised nature of the asset creates a situation of bilateral monopoly, in which only one firm buys, and one firm sells the specialised asset or resource.

Production takes place therefore at lowest marginal costs, but there might be dispute of how to share the profits; the price will then lie between monopoly price and competitive market

A vertical integration between these companies can optimize output and increase profits. The optimal point is where marginal revenue at the retail level corresponding to marginal costs at producer level - effectively double marginalization again.

Asset specificity may be symmetric; but also unilateral, so that only one party has invested in specific assets connection. transaction

This may lead to a so called ‘hold-up’ problem: one party is dependent on the other; but the reverse is not true

Question 24

What are the four types of asset specifity?

Answer 24

Site specificity. By having plants located close to one another, there is a saving on transportation, processing and inventory costs. The assets cannot be moved to other locations without increasing costs.

Physical asset specificity. Plant and machinery that is designed with a limited end use, either for use by one buyer or with one input, is specific to one market transaction. Such investments offer little or no return in alternative uses.

Human asset specificity. Human capital, in the form of specialised knowledge and experience that has been developed by a firm’s managers or workers, may be essential for one supplier but irrelevant and therefore worthless elsewhere.

Dedicated assets. A firm may be forced to make large-scale investments in dedicated assets to meet the needs of one large buyer. If the buyer decides to go elsewhere, the firm is left with excess capacity.

Question 25

Why might a company vertically disintegrate?

Answer 25

Initially, when markets are small, there is a tendency for integration of the various stages of the supply chain. As markets develop and become larger, however, benefits may be obtained from specialization and economies of scale at different stages of the supply chain, and there may be a tendency towards vertical disintegration.

Whether a company can produce its own input also depends on the horizontal competition in the downstream stage.

If the competitors are also going to buy inputs the vertically integrated company can realize economies of scale in the production of inputs - cost savings by increasing size