Week 3 - Integration and its Alternatives

Question 1

Why do asset ownership and specificty matter?

Answer 1

Because contracts incomplete (not cover every possibility) so issue of asset ownership and control changes the bargaining power of parties in relationship

Question 2

What is the result of contracts being incomplete?

Answer 2

Firm more likely to be vertically integrated if impact of owning asset has greater impact on its value chain and costs

Question 3

What are the main drivers of vertical integration?

Answer 3

• Economies of Scale and Scope
  When outside market specialists able to take advantage of economies of scale the firm gains less from vertical integration
• Market Size and Growth
  Gains from larger share of the product market
• Asset Specificity
  When investments in relationship specific assets, if large dominates over other two factors

Question 4

What is the theory of Coase? (Vertical Integration theory)

Answer 4

Decisions to make or buy will be determined by transactions cost minimising motives (cost of internalising an extra transaction will equal the cost of organising the transaction in the market)

Question 5

What are the costs of the market system?

Answer 5

The cost of discovering prices
The costs of drawing up contracts
The difficulties of specifying details in a long-term contract

Question 6

What are the costs of direct control?

Answer 6

Inflexibility

Lack of Competition

Question 7

What is Williamson’s view on vertical integration?

Answer 7

• Asset Specificity - Key Issue
• Assets that have value in alternative uses/ users that are much lower than present use.
• Hence, bargaining will necessarily involve small numbers and will therefore be a costly process, if engage in repeatedly.
• Opportunistic re-contracting is likely: one party changes the terms once the other party is already committed.

Question 8

How does Williamson argue about the choice between market or vertical integration?

Answer 8

The choice depends on the relative importance of technical and agency costs

Question 9

What is Technical Efficiency?

Answer 9

Achieved when firm uses the least-cost production process (either in-house or by relying on the market).

Question 10

What is Agency Efficiency?

Answer 10

Achieved when the costs of coordination, agency and transaction costs are minimised.

Question 11

How do you calculate technical efficiency?

Answer 11

Change in T = - (Prod Cost in-house - Prod Cost external)
(SEE NOTES)

• Assume both in and out house are producing as efficient as possible
• Generally assumed that using the market leads highet technical efficiency compared to VI

Question 12

How does Asset Specificity impact the dif of technical efficiency of market over VI?

Answer 12

Depends on the nature of the assets involved in production, which may become strong enough to counteract the assumed superiority of a market solution

Greater asset specificity = Declining difference

Question 13

How do you calculate the agency efficiency?

Answer 13

Change in A = (Transaction cost in house - Transaction cost external)

(SEE IN NOTES)

• Where change in A when activity produced in-house trans cost when activity provided by market specialist

Question 14

How did Lyons (1995) describe the change in A?

Answer 14

Bureaucratic cost of internal organisation less the governance costs of markets

Question 15

What are considered as Transaction Costs when performed by a market specialist?

Answer 15

• direct costs of negotiating contracts costs of safeguards against hold-up
• costs of safeguards against hold-up.
• inefficiencies due to under-investment in relationship-specific assets and lost opportunities for cost savings due to mistrust.
• costs associated with breakdowns in coordination and synchronization when activity is purchased

Question 16

What are considered transaction costs when an activity is performed in house?

Answer 16

agency and influence costs that arise from internal organization.

Question 17

What happens with Agency efficiency when there is low asset specificity?

Answer 17

At low levels of asset specificity, differential agency efficiency of market over vertical integration (change in A) is likely to be positive

Without the holdup problem, market exchange could be more “agency efficient” than in-house production

Question 18

What happens with Agency Efficiency when there is high asset specificity?

Answer 18

At high levels of asset specificity, differential agency efficiency ( change in A) of market over vertical integration is negative
When specialized assets are involved, potential for a holdup by the supplier is high and the transactions costs are higher

Question 19

How do you calculate the full cost difference between vertical integration and reliance on an external market specialist?

Answer 19

Change in C = Change in T + Change in A
=(Prod cost in house - Prod Cost External) + (Trans Cost in house - Trans cost external)
= Total cost in house - Total cost external

Question 20

So hows does the full cost difference help to choose a decision between VI and market specialist?

Answer 20

Involves assessment of the lowest cost way of producing taking both production and transaction costs into account

Question 21

What happens when the change in C is positive?

Answer 21

In-house production more costly than reliance on market specialists, so a vertically separated solution should be preferred

Question 22

What happens when the change in C is negative?

Answer 22

In-house production less costly than reliance on market specialists, so a vertically integrated solution should be preferred

Question 23

What is the market and in house production better at?

Answer 23

• Market: Better at achieving technical efficiency

- In-house production: Minimising Transaction costs

Question 24

What does Williamson mean when he says economising the attempt to balance these two elements?

Answer 24

Williamson arguing that market firms are more likely to be able to benefit from economies of scale or scope (especially when a firm’s demand for an input is relatively small relative to the market demand for it)

Question 25

When is the optimal degree of vertical integration?

Answer 25

Achieved when sum of technical and agency inefficiencies (change in C) is minimised

Question 26

What does the optimal degree of vertical integration depend on?

Answer 26

Depends on the asset specificity involved in the transaction and on the size of the transaction

Question 27

Explanation of asset specificity increase diagram (SEE DIAGRAM IN NOTES)

Answer 27

-With Low Asset Specificity (below k*) – Both production costs and transaction costs are superior with vertical separation (market solution)

• Between k* and k** production costs still superior with market solution, but transaction costs favour vertical integration.
• However overall cost differential ∆C still favors vertically separated market solution
• In excess of k** transaction costs of market solution (high holdup costs) are so strong that they dominate any production cost benefit from a market solution and ∆C<0 indicating superiority of internal vertically integrated solution

Question 28

What happens high and low levels of asset specificity?

Answer 28

• High levels: VI more efficient (cost effective)

- Low Levels: Market based on based solutions more cost effective than VI

Question 29

What occurs when the scale of internal production increases? (Part 1)

Answer 29

When internal production increases the VI firm enjoys better EofS e.g. better costs of production

(Increased scale, technical efficiency differential decreases for every lvl of asset specificity)

Question 30

What occurs when the scale of internal production increases? (Part 2)

Answer 30

Increase in scale, agency efficiency differential becomes more sensitive to asset specificity.

The differential will:

• Increase with scale for low asset specificity
• Decrease with scale with high asset specificity

Question 31

What happen with total cost efficiency when scale occurs? (SEE DIAGRAM IN NOTES)

Answer 31

assumes that the impact of increased scale on production costs is always stronger than the impact on transaction costs, so the Total Cost Efficiency Differential becomes smaller for all levels of asset specificity (k) meaning that the level of asset specificity at which vertical integration is preferred declines from k** to K***

Question 32

What were Lyon’s hypothesises when testing Williamson’s theory?

Answer 32

H1: Inputs requiring specific production technology more likely to be produced in-house
H2: Inputs requiring EofS or Scope less likely to be produced in-house (if size of market demand for the input is small relative to market’s demand)
H3: EofS or Scope have greater impact on the make or buy decision in absence of specific assets (e.g. if asset specificity increases, agency cost associated with hold up reduce the potential benefits of market firm based EofS cost reductions)`

Question 33

What are the key variable used in Lyon’s test of Williamson’s argument? (PT 1)

Answer 33

SUBCON: Either input is subcontracted (SUBCON i=1) or made in-house (SUBCON i= 0)

IDEAL: =1 Affirmative answers =0 for negatives (proxy for increases in asset specificity (k))

Question 34

What are the key variables used in Lyon’s test of Williamson’s argument? (PT2)

Answer 34

ES = CostElas10*
Reflects existence of significant economies of scale with dummy variable= 1
e.g.If the firms thought that a doubling of their demand for the input doubled would result in a a decline of at least a 10% in average production costs of the input

Small Demand: Queries ‘production involved eofs and requirements not large enough to exhaust them’
TRUE=1
FALSE= 0

THEREFORE ES EQUALS 1 FOR FIRMS THAT BELIEVE SIGNFICANT ECONOMIES OF SCALE EXIST IN PRODUCING AN INPUT BUT ONLY IF THEY BELIEVE THEIR DEMAND IS SMALL RELATIVE TO THE MINIMUM EFFICIENT SCALE

Question 35

How did Lyon test his theory on Williamson’s hypotheses?

Answer 35

Questionnaire sent to sample of firms in mech engineering,motor vehicles etc.
- Asked about make or buy decisions via q’s about product they contracted out and in-house products. Asked also on asset specificity and EofS.

Subcon = -0.238 - 0.742IDEAL +2.231ES - 1.702IDEALES

Confirming Williamson hypothesis somehow IDEK

Question 36

What are the answers to the 3 hypotheses (SEE NOTES)

Answer 36

H1:
Coefs on IDEAL and IDEALES both <0
Change in Subcon/Change in IDEAL = -0.742 - 1.702*ES

H2:

• Direct Coef on ES>0
• Change in Subcon/Change in ES = 2.231 - 1.702*IDEAL

H3:

• Coef on IDEAL*ES<0
• Yes as derivative for H2 if there is asset specificity firm’s are less likely to subcontract in response to the presence of market based economies of scale
• Similarly in H1 derivatve subcontracting is less likely as ES goes up because of this effect

Question 37

What is the criticism of Williamson?

Answer 37

Implication: When significant asset specificity, VI likely
Criticism: When does integration not occur?

• GHM’s ‘Contractual Rights’ Approach tackles this

Question 38

What is the GHM theory of Vertical Integration?

Answer 38

Existence of various degrees of vertical integration as the result of balance in ownership and control of transaction specific assets (GHM theory).

If contracts were complete then it would not matter who owns the assets relevant to particular transaction.

Question 39

EXPLANATION OF GHM VI Theory?

Answer 39

Since in real life contracts are incomplete then asset ownership determines the right of control.

The right of control over assets will allow the owner to extract most of the value of the transaction and will increase its willingness to make relationship-specific investments.

Question 40

What is the predictions of the GHM theory?

Answer 40

Complementary assets should be owned by a single firm

Independent assets should be separately owned

Question 41

What are the alternatives to VI: Tapered Integration

Answer 41

The company produces in-house part of the inputs required but also ‘delegates’ to market firms part of the production

Flexibility to grow without big capital outlays, gaining of valuable cost information to help in negotiation with market firms and protection against holdup problems

Question 42

What are the alternatives to VI: Collab Relationships and Supplier Network

Answer 42

Based on trust, social norms, long-term relationships.

Sub-contractor networks, chaebols, and keiretsus (dif types of organisations). Long-term relationships and implicit contracts support cooperation among firms.

Long term market relationships can provide strong incentives for cooperative behavior, thereby gaining some of the benefits of vertical integration (avoidance of transaction costs, flexibility in governance).

Question 43

What are the alternatives to Vertical Integration? Vertical Restraints

Answer 43

e.g. resale price maintenance (books) exclusive distribution and exclusive dealing (often relevant in retailing) (see industrial policy course).

Question 44

What are the alternatives to Vertical Integration? Franchising Arrangements

Answer 44

Increasingly popular form of organisation for retailing markets which allows to producing company to share risks and profits with the local managers who have better knowledge of the local market.

Involves partial ownership of capital assets by both parties and it is generally implemented through a fixed fee and an output (or sales) related (variable) fee