Week 4 - Integration and Its Alternatives

Question 1

What do incomplete contracts cause?

Answer 1

• Coordination problems
• Information leakage and
• Hold up problems
  This leads to inefficient production (and can easily occur as contracts are invariably incomplete).

Question 2

What can ensure efficient production?

Answer 2

Integration.

Question 3

How does integration affect the performance of the vertical chain?

Answer 3

The Property Right Theory (PRT) explains this:
Integration determines the ownership and control of assets, and it is through ownership and control that firms are able to exploit contractual incompleteness.

Question 4

Why does integration matter?

Answer 4

Because it determines who gets to control resources, make decisions, and allocate profits.
- Ownership affects the willingness of parties to invest in relationship-specific assets.

Question 5

Consider two firms each of which has its own managers. Suppose firm 1 is upstream from firm 2 in the vertical chain. What are the 3 alternative ways to organise the transaction?

Answer 5

• Non-integration: The two firms are independent; each set of managers has control over its own assets.
• Forward Integration: Firm 1 owns the assets of firm 2; i.e., firm 1 forward integrates into the function performed by firm 2 by purchasing control over firm 2’s assets.
• Backward Integration: Firm 2 owns the assets of firm 1.

Question 6

What is horizontal integration?

Answer 6

This is the process of a company increasing production of goods or services at the same part of the supply chain. A company may do this via internal expansion, acquisition or merger. This often results in the market becoming more concentrated. The process can lead to monopoly if a company captures the vast majority of the market for that product or service.

Question 7

What are some examples of horizontal integration?

Answer 7

• Webjet entered into a binding heads of agreement to acquire SunHotels Group (European online hotel provider) in 2014.
• Expedia completed a $703 million takeover of Wotif in November 2014.
• Disney and Pixar:
  o Since 1991, Disney outsourced the production of computer-animated feature films to Pixar.
  o Toy Story (1995) ended up being a massive hit = P and D began having disagreements as P complained the arrangement was not equitable.
  o P was responsible for creation and production, D handled marketing and distribution (profits were split 50-50, but D exclusively owned all story and sequel rights and also collected a distribution fee).
  o In the end, D ultimately agreed to buy P for approx. $7.4 billion in 2006
• Pepsi has 2 types of bottlers: independent and company owned
  o They are now keen to gain more control over the distribution of its growing menu of offerings.
  o After the acquisition, Pepsi no longer would have to persuade its big bottlers to take on each new product (less time-consuming process).
• Netflix makes its own TV series and movies

Question 8

What does PRT establish?

Answer 8

• The form of integration affects the incentives of both sets of managers to invest in relationship-specific assets.
• This includes both ex ante investments and ongoing investments.
• These investments may cost one firm more than another, each set of managers may haggle over responsibilities with the result that there is inefficient adaptation to the changing market environment.

Question 9

What does PRT imply?

Answer 9

• Vertical integration is desirable when one firms investment in relationship-specific assets has a significantly greater impact on the value created in the vertical chain than does the other firm’s investment.
• When the investments of both firms are of comparable importance, non-integration is the best arrangement, as both firms’ managers will have sufficient incentives to invest while remaining independent.
• This suggests that there are trade-offs in alternative ownership structures.

Question 10

What are some important factors to consider when making the integration decision?

Answer 10

• Scale and scope economies
• Product market share and scope
• Asset specificity
• Double marginalisation

Question 11

Why must firms consider scale and scope economies when making the integration decision?

Answer 11

• A firm gains less from vertical integration when outside market specialists are better able to take advantage of economies of scale and scope.
• A key source of economies of scale and scope is “indivisible,” upfront “setup” costs, such as investments in physical capital or in the development of production know-how.
• Suppose an input requires significant upfront setup costs, and there is a large market outside the firm for the input, then the firm should buy the input from outside market specialists.
• This will often be the case for routine products and services that are capital intensive.

Question 12

Why must firms consider product market share and scope when making the integration decision?

Answer 12

• The more the firm produces, the more its demand for inputs grows. This increases the likelihood that in-house input production can take as much advantage of economies of scale and scope as an outside market specialist.
• A firm with a larger share of the product market will benefit more from vertical integration than a firm with a smaller share of the product market.
• A firm with multiple product lines will bene.t more from being vertically integrated in the production of shared components.
• It will benefit less from being vertically integrated in the production of components for “boutique” or “niche” items that it produces on a small scale.

Question 13

Why must firms consider asset specificity when making the integration decision?

Answer 13

• A firm gains more from vertical integration when production of inputs involves investments in relationship-specific assets.
• If asset specificity is significant enough, vertical integration will be more profitable than arm’s-length market purchases, even when production of the input is characterized by strong scale economies or when the firm’s product market scale is small.

Question 14

Why must firms consider double marginalisation when making the integration decision?

Answer 14

• When a firm with market power (e.g., an input supplier) contemplates vertical integration with another firm with market power (e.g., a manufacturer), it needs to consider one additional factor known as double marginalization.
• A firm with market power sets its price above marginal costs.
• Double marginalization results when an upstream supplier exploits its power by marking up prices above marginal costs, and the downstream buyer exploits its own power by applying yet another mark-up to these already marked-up supply prices.
• This “double mark-up” causes the price of the finished good to exceed the price that maximizes the joint profits of the supplier and buyer.
• Through integration, the downstream firm can base its mark-up on the actual marginal costs of production, rather than the artificially inflated supply prices set by the independent supplier. In this way, the integrated firm uses just the right amount of market power and maximizes its profits.

Question 15

Besides “make” and “buy” decisions, what are the 4 “hybrid” ways of organising exchange?

Answer 15

• Tapered integration, in which the firm both makes and buys a given input
• Franchising
• Strategic alliances and joint ventures
• Close-knit semiformal relationships among buyers and suppliers, often based on long-term implicit contracts that are supported by reputations for honesty, cooperation, and trust.

Question 16

What is tapered integration?

Answer 16

This represents a mixture of vertical and market exchange.

• A manufacturer might produce some quantity of an input itself and purchase the remaining portion from independent firms.
• It might sell some of its product through an in-house sales force and rely on an independent manufacturers’ representative to sell the rest.
• Examples: Coca-Cola and Pepsi = they have their own bottling subsidiaries, but also rely on independently owned bottlers to produce and distribute their soft drinks in some markets.

Question 17

What is franchising?

Answer 17

The franchiser (e.g., McDonald’s Corporation) gives partial ownership rights to franchisees

(e. g., owners of local McDonald’s restaurants).
- Franchising allows small-business owners such as Ray Kroc (McDonald’s) and Adriaan van Well (SPAR) to grow rapidly.
- Franchisees put up the capital to build and operate their stores and pay a fee for the right to use the franchiser’s name and business model.
- Franchisers may also require franchisees to purchase from designated suppliers, offer specific products, and conform to architectural and design guidelines.

Question 18

What are the benefits of franchising?

Answer 18

• The franchiser performs tasks that involve substantial scale economies, such as purchasing and branding.
• Franchisees keep their residual profits, giving them strong incentives to make investments to serve their local markets, such as identifying good locations and tailoring product selections to local tastes.
• By allocating decision rights in these ways, there is little lost and much gained by dispersing ownership of individual franchises.
• Franchisers do sometimes face free-riding problems as retailers bene.t from the corporate brand reputation. For example, a McDonald’s franchise owner can expect a certain amount of business based on brand name alone and may be tempted to cut corners on quality.
• Franchisers often maintain tight quality control through frequent surprise inspections, and by dictating certain aspects of production, including choice of suppliers and employee uniforms.

Question 19

What are strategic alliances and joint ventures?

Answer 19

• Since the 1970s, firms have increasingly turned to strategic alliances as a way to organize complex business transactions collectively without sacrificing autonomy.
• Alliances may be horizontal, involving collaboration between two firms in the same industry, as when Sina (China’s main Internet portal) and Yahoo partnered to offer auction services in China.
• Alliances may be vertical, such as when Moroccan tile manufacturer Le Mosaiste teamed up with Los Angeles interior designer Vinh Diep to create computer-aided design renderings of Le Mosaiste’s mosaic tiles in “real-world” living spaces.
• They may involve .rms that are neither in the same industry nor related through the vertical chain, as when Toys “R” Us and McDonald’s of Japan allied to build Toys “R” Us stores in Japan that would include a McDonald’s restaurant.
• A joint venture is a particular type of strategic alliance in which two or more firms create, and jointly own, a new independent organization.