Week 2 - Vertical Boundaries of the Firm Flashcards

1
Q

Why is organising the value chain an important part of business strategy? (Part 1)

A
  • Production of any good/service requires wide range of activities organised in vertical ‘value’ chain
  • Production activities said to flow from upstream suppliers to downstream manufacturers,distributors and retailers
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2
Q

Why is organising the value chain an important part of business strategy? (Part 2)

A
  • Activities in the chain include activities, which are:
    1. Associated directly with processing and distribution of inputs and outputs
    2. Professional support activities, like accounting and planning
  • Understanding vertical relationships important for business strat because influence the firms composition
    e. g Business must make a buy/make choice
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3
Q

What is the processes upstream and downstream?

A
  1. Raw inputs
  2. Transportation
  3. Good processors (mills etc.)
  4. Transportation
  5. Assemblers
  6. Transportation
  7. Retailers

Also support services such as accounting etc.

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4
Q

What is the make or buy decision?

A

Act of making a strategic choice between producing an item internally (in-house) or buying externally (out-house)

  • Firm can produce in-house (vertical integration) or rely on market forces to provide the most efficient version of these products
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5
Q

What are the differing possibilites of the make or buy decision?

A
  • Not a yes or no answer and is instead a spectrum
    List goes from less integrated to more integrated:
Arm's length market transaction
Long-term contracts
Strategic Alliances and Joint Ventures
Parent/Subsidiary Relationship
In-house production
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6
Q

What are the advantages of vertical separation (buy)?

A
  • Lower costs, due to strong market competition
  • Economies of Scales in the specialised activity
  • Expertise and market incentives in vertically related markets
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7
Q

What are the advantages of using the market? (PT 1)

A
  • Cost savings from specialisation passed on to other phases in vertical chain (downstream) only if the market is competitive
  • Specialisation limited by the size of the market. One supplier might be able to serve several buyers and rely on large market size to provide a cost advantage via economies of scale in the specialised product
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8
Q

What are the advantages of using the market? (PT 2)

A
  • Reduction in agency costs:
    (Slacking by employees and resulting monitoring and motivating workforce) - Higher in large companies, market firms have to reduce these costs to stay competitive

Reduction of Influence Costs:
(Time needed to influence to get resources)

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9
Q

What are the advantages of Vertical Integration? (Make)

A
  • Effective control over supply chain (e.g unreliable suppliers)
  • When market info critical for production schedules
  • When specific assets required
  • In presence of concentrated upstream and downstream markets
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10
Q

What are the disadvantages of using the market? (PT 1)

A
  • Cost of co-ordinating activities in separate companies across vertical chain
  • Contracts might be inadequate to deal with co-ordination problem when small errors can be costly (Better to co-ordinate internally)
  • Unwillingness of suppliers/buyers to develop and share valuable info - Especially around IP’s or patents
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11
Q

What’s meant by the co-ordination of production flows?

A
  • Firms make decisions that depend in part on decisions made by other firms along vertical chain
  • Without good co-ordination, bottlenecks arise in vertical chain
  • To ensure co-ordination, firms rely on contracts but if contracts cannot be written or transaction costs related to them are high enough co-ordination justifies vertical integration
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12
Q

What are the disadvantages of using the market? (PT 2)

A
  • Limited protection via contracts
  • Main costs associated with using the market are related to the costs of negotiating, writing and enforcing contracts (Transaction cost econ)
  • Cost of protecting the company from potential opportunistic behaviour via complex contracts may be too high
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13
Q

What are the factors that prevent complete contracting?

A
  • Bounded Rationality:
  • Difficulties in specifying/measuring performance
  • Asymmetric Information
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14
Q

What’s meant by complete contracting?

A

If the parties to an agreement could specify their respective rights and duties for every possible future state of the world, their contract would be complete.

-There would be no gaps in the terms of the contract.

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15
Q

What’s meant by bounded rationality?

A
  • Individuals have limited capacity to process information, deal with complexity, and pursue rational aims
  • Individuals cannot foresee all possible contingencies
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16
Q

What’s meant by Difficulties in specifying/measuring performance?

A

-Performance cannot always be measured unambiguously, as What constitutes fulfillment of a contract may have some residual vagueness.

17
Q

What’s meant by Asymmetric Info?

A

Parties to the contract may not have equal access to contract-relevant information, and the knowledgeable party can misrepresent information with impunity, thereby making Contracting on items that rely on this information is difficult

18
Q

What is the relation between contracts and the potential leakage of private information?

A

Firms do not want to compromise the source of their competitive advantage and private information on product design or production know-how may be compromised when outside firms are used in the vertical chain.

19
Q

How can companies prevent the leakage of Private Info?

A
  • Well defined patents can help (not full protection)

- Contracts with non-compete clauses can be used to protect leakage of info, but hard to enforce

20
Q

What does using the market require?

A

Transaction costs -

Cost of negotiating, writing and enforcing contracts

21
Q

What are the sources of transaction costs?

A
  • Contracting Costs and Cost of Contracting
  • Investments that need to be made in relationship specific assets
  • Possible opportunistic behaviour after the investment is made (holdup problem) and the potential Quasi-rents associated with holdup
    `
22
Q

What are relationship specific assets?

A
  • These assets cannot be redeployed for another transaction without cost
  • Once asset in place, other party to the contract cannot be replaced without cost as parties locked into relationship (can cause hold-up problem)
23
Q

What are some of the different forms of relation specific asset specificity?

A
  • Site Specificity
  • Physical Asset Specificity
  • Dedicated Assets
  • Human Assets Specificity
24
Q

What’s meant by Site Specificity?

A
  • Assets may have to be located in close proximity to economise on transport costs and inventory costs
    e. g cement factories close to stone deposits
25
Q

What’s meant by Physical Asset Specificity?

A
  • Physical Assets may have to be designed specifically for the particular transaction
    e. g. Molds for glass containers production custom made for particular user
26
Q

What’s meant by Dedicated Assets?

A
  • Some investments made to satisfy single buyer without whom the business would not profitable
    e. g. Defence contractor’s investment into manufacturing facility for making certain advanced weapon systems
27
Q

What’s meant by Human Asset Specificity?

A
  • Some of the employees of the firms engaged in the transaction may have to acquire relationship-specific skills, know-how and info
    e. g workers acquire skills to use particular entreprise resource planning software
28
Q

What is the Hold-up problem?

A

E.g once the supplier (purchaser) has invested in the asset to produce (use) an input , the purchaser can request a lower price (supplier can demand a higher price)

Essentially squeeze them by the balls

-Complete contract would not allow this

29
Q

What is the effect of the hold-up problem on transaction costs?

A

Raises the cost of transacting exchanges

  • Negotiations more difficult
  • Investments may have to be made to improve ex-post bargaining position
  • Distrust
  • Could lead to underinvestment in relationship specific assets
30
Q

What are some of the safely cost guards that can prevent the hold up problem?

A

Potential for holdup may lead parties to invest in wasteful protective measures
E.g. Manufacturer may acquire standby production facility for an input that is to be obtained from a market firm
- Vertical Integration (make) more likely with potential hold up