Vertical Integration Flashcards
What is the definition of vertical integration, and what is upstream and downstream integration?
Vertical integration is a strategic move to increase the firm’s scope of activity.
Vertical integrations cover the firm’s ownership of vertically related activities over its value chain; up- and downstream: upstream (supplying etc.) and downstream (distributing etc.) activities
When to vertically integrate, according to the theory?
Simple way to decide (But not optimal):
If transaction costs (market/external)) >
transaction costs (administration/Internal)
Then internalize activity to firm
Else source activity from the market
An integration decision is more complex than simply comparing total transaction and administrative costs.
Vertical integration makes sense if benefits of internal coordination outweigh contracting on market -> this change over time.
If the market can perform the activity to a lower cost than the firm, buy from the market.
Explain the difference between transaction and coordination costs.
Transaction costs: Operational: • Search Costs. • Transportation costs. • Inventory holding costs. • Communication costs • Quality assurance costs Contractual: • Negotiation (Contract) Costs • Enforcement (Control) Costs
Cost incurred when buying goods in the market.
Coordination/administrative costs: Operational • Salaries • Overhead Contractual • Negotiation • Enforcement.
Internal administrative costs incurred when producing goods within the firm.
What are the benefits of vertical integration?
- increase control → reduced risk?
- increase coordination → reduced costs?
- Increase flexibility → reduced dependence?
Efficiencies from physical integration of processes.
By vertically integrating, transaction costs of a rivalry restrained market can be avoided:
- Monopolies or small number of firms
- transaction-specific investments (if continued investments are required, it can be beneficial to consider vertical integration).
- Opportunism (Agency problems/principal-agent problem): conflict of interest. Suppliers cutting corners acting in their own interest and not in the buyers interest. Lacking quality.
- Taxes and regulations on market transactions.
What are the costs of vertical integration?
Losing focus: risk of developing distinctive capabilities (think VRIN). If activity is not of strategic relevance, don’t integrate/consider outsource.
Difficulties of managing strategically different businesses.
Limits flexibility
- In responding to demand fluctuations.
- In responding to changes in technology. (is there a need for flexibility to chose between vertical components? If yes, consider outsourcing/don’t integrate).
- Compounding of risk and interdependencies between stages.
Investing in inherently unattractive businesses.
Incentive misalignment (Agency problems/opportunism)
Give an example of a downstream integration, and explain the reasons behind the choice to integrate the activity.
Insurance companies adopt relevant technologies quicker and develop more innovative products.
- Some demand uncertainty (which products)
- Some technology uncertainty (how to use tech)
Forward/downstream integration allows for collecting market feedback on usage to develop new and improved solutions. Enabling innovation.
Give an example of an upstream integration, and explain the reasons behind the choice to integrate the activity.
Tesla upstream integrated in a number of segments:
Battery technology: to reduce dependency on single suppliers.
Car seats: To increase flexibility in design.
Low demand uncertainty
High supply uncertainty.
Integration ensures higher value capture.
Explain the complement challenge and give an example of it.
When innovations occur in components to a focal offer it is sometimes hard to integrate this new or improved component into the focal offer. New and improved engines from Rolls-Royce are differently sized and therefore difficult to implement on existing Airbus models.
The Airbus A380 can only create value when key complementors are implemented, such as new terminals that can handle the oversized aircraft.
Many innovations rely on the availability of complements to unlock their full value.
Are technologies more likely to be integrated early or late in their maturity life cycle? And why?
Technological challenges decrease as technology matures.
Contractual hazards do not. But as vertical integration does not handle the technological challenges it handles the contractual hazards, why vertical integration will be valued more over the course of the technology life cycle – the more mature a technology is, the more likely it is to be vertically integrated.
Which of these is not typically considered a transaction cost?
- Bureaucratic Costs
- Search Costs
- Negotiation Costs
- Enforcement Costs
Bureaucratic Costs
True or False?
The concept of ‘opportunistic behaviour’ refers to changes in market participants’ actions in order to maximise their utility.
True
True or False?
Partial forward vertical integration refers to the extension of some but not all activity located downstream in an industry value chain.
True
True or False?
A specific firm activity should not be considered for outsourcing if the activity is offered by many suppliers in the market.
False
Which of the following statements about integration decisions is not correct?
- A firm should consider integration when technology uncertainty is lower than behavioral uncertainty.
- A firm should consider integration if the targeted activity matches the scale of the firm’s operation.
- A firm should consider integration if the targeted activity is of strategic relevance for value creation.
- A firm should consider integration if flexibility in the targeted activity changes is needed.
A firm should consider integration if flexibility in the targeted activity changes is needed.
Name 3 different decision criteria for vertical integration
- Are few firms available to transact with adjacent activity – If yes, consider integration
- Are transaction specific investments needed for interaction between value chain components – If yes, consider integration
- Is information asymmetric between adjacent value chain components – If yes consider integration
- Are taxes or regulation imposed on transactions – If yes, consider integration
- Do different stages have similar optimal scales of operation – If yes, consider integration
- Is continued investment required in activity – if yes, consider integration
