Vertical Integration Flashcards
Approach #1: The direction of resources depends directly on the price mechanism
“The normal economic system works itself. For its current operation it is under no central control, it needs no central survey. Over the whole range of human activity and human need, supply is adjusted to demand, and production to consumption, by a process that is automatic, elastic and responsive”
Approach #2: Economic planning
Now, there are many areas in which the approach #1 donot apply
-> If a workman moves from department Y to
department X, he does not go because of a change in
relative prices, but because he is ordered to do so
So, there is planning within our economic system beyond
individual planning. This is the Economic planning
Transaction costs: Beyond the mechanism price
-Price mechanism is admitted as a coordinating instrument but also
the coordinating function of the entrepreneur
- There are costs of using the price mechanism
-> Cost of organising production
-> Costs of negotiating and concluding a separate contract for each
exchange transaction
- By forming an organisation and allowing some authority (an
entrepreneur) to direct the resources, certain costs are saved.
Authors’ perspectives on the Economic planning
Marshall: organisation as a fourth factor of production
J. B. Clark : entrepreneur coordinates
Maurice Dobb : the undertaker busies himself with the division of labour inside each firm and he plans and organises consciously
Then, why are there any market transactions at all in the real world ? Why is not all production carried on by one big firm ?
Diminishing returns to management.
• As a firm gets larger, there may be decreasing returns to the entrepreneur function
• As the transactions (which are organised) increase, the entrepreneur fails to make the best use of the factors of production.
What defines the growth of a firm?
Larger if:
- The less the costs of organising and the slower these costs rise with an increase in the transactions organised
- The less likely the entrepreneur is to make mistakes and the smaller the increase in mistakes with an increase in the transactions organised
- The greater the lowering (or the less the rise) in the supply price of factors of production to firms of larger size.
How can a firm expand?
- Lateral integration (horizontal): when transactions that were previously organised by two or more entrepreneurs become organised by one
- Vertical integration: when this involves the organisation of transactions, which were previously carried out between the entrepreneurs on a market
Economic definition of a firm is based on:
- Marketing costs (costs of using the price mechanism)
- Costs of organising of different entrepreneurs
- Cost curve apparatus
-> This is a realistic ( fits with the legal definition1in the real
world) and operative (when we are considering how large a
firm will be the principle of marginalism works smoothly )
definition
Define and elemental versions of four theories of the firm:
- Rent-seeking theory
- Property-rights theory
- Incentive system theory
- Adaptation theory
Rent seeking Theory
tailor wants integrate with me to stop haggling over quasi approbriable rents
The problem is after haggling and who takes what in surplus
Integration can stop socially destructive haggling over “appropriable quasi−rents”. Thus larger AQRs make integration more likely, presumably because larger AQRs make socially destructive haggling either more likely or more costly or both.
In sum, what the theory claims is that larger AQRs make non-integration more costly ( not an inference about the likelihood of integration until we say something about the costs of integration )
A quasi-rent occurs when one makes an investment and pays for it, and then earns income from it without needing to make further investment.
Property rights
Ice Cream machine owned by person whos contribution is more important for the business
Inverse of the rent-seeking theory
- Where the rent-seeking theory envisions socially destructive haggling ex post, the property-rights theory assumes efficient bargaining
- Where the rent-seeking theory is consistent with contractible specific investments ex ante, the property rights theory assumes there may be
inefficiency
- Here, efficient bargaining causes the parties to share the surplus from their specific investments, owning more assets can guarantee a bigger surplus share and so creates a stronger investment incentive.
- If it is important to maximize one party’s investment, then that party should own all the assets, whereas if the parties’ investment incentives are both important, then dividing the assets between the parties is efficient.
- > In sum, the integration decision determines ex ante
investments and hence total surplus, whereas in the rent seeking theory, the integration decision determines ex post haggling and hence total surplus.
Properrty rights vs rent seeking
Rent seeking: beginning - everything is fine and contract after things can get worse
Property: beginning - everything is bad and after contract things get better
Incentive system
Rent- seeking and property-rights theories focus on the make-or-buy problem and include ‘control’ while the incentive theory focuses on principal and an agent problem and consider agent’s action space is not
affected.
So, the agency problem can be structured in two ways: the agent is an employee or an independent contractor
In sum, what this theory claims is that asset ownership can be an
instrument to alleviate incentives problems
Effort depends on if people are inside the firm oder outside the firm
Adaptation
More uncertainty - want to integrate more
This theory asks whether integration or non- integration better facilitates “adaptive, sequential decision-making” in environments where uncertainty is resolved over time
Neither contracts ex ante nor renegotiation ex post can induce first-best adaptation after uncertainty is resolved. Then, the second-best solution may be to concentrate authority in the hands of a “boss” who then makes decisions after uncertainty is resolved
Ex ante incentive alignment and ex post decision governance
Ex ante incentive alignment: incentive system and property rights
Ex post decision governance: rent seeking and adaption
