Week 5 Flashcards
Vertical integration
When a firm takes over ownership of its production, of its inputs, or of the channels it uses to distribute its output.
Diversification
Variety of products a firm offers, or the markets/geographic locations it competes in.
Corporate strategy
Diversification and Vertical Integration are part of corporate strategy.
Corporate strategy involves the decisions that leaders make and the goal-directed actions they take to gain competitive advantage in several industries/markets.
Business strategy on the other hand focuses on how to compete in a single product market.
3 dimensions of corporate strategy that managers need to decide on
- Vertical integration (which stages of the value chain should the firm participate in?);
- Diversification (what range of products and services should the firm provide?);
- Geographic scope (where should the firm compete geographically?).
Outcome of a firm’s corporate strategy
A large outcome for a firm’s corporate strategy is usually growth.
Firms grow for a number of reasons. These include: increased profits, lowered costs (as larger companies have more economies of scale), increased market power, reduced risk (due to diversified product portfolios), and a more motivated management.
However, businesses can also fail because they grow in the wrong way: too fast, too soon, or based on shaky assumptions about the future. In addition, some firms do not want to grow. For example, small family businesses who currently have convenience and stability might think that growth is not in their best interest.
Core competencies
Core competencies are unique strengths embedded deep within a company. They also allow firms to differentiate their products and create higher value, or have lower costs than competitors.
Core competencies and activities a firm does well should be done in-house. Therefore, according to the resource-based view, a firm’s internally held knowledge and core competencies determine its boundaries.
Economies of scale
When a company’s average cost per unit decreases as the output increases.
Economies of scope
Savings that come from producing two (or more) outputs at less cost than producing each individually, through using the same resources or technology
Transaction costs
These are all the internal and external costs associated with an economic exchange.
Transaction costs show that different institutional arrangements (such as markets vs. firms) have different costs attached to certain resources.
2 types of transaction costs
- External transaction costs are associated with the market and include things like enforcing contracts.
- Internal transaction costs are associated with the firm and include things like costs of recruiting, or paying salaries and benefits. Internal costs tend to increase when organizational size or complexity increases.
Make or buy decisions
Transaction cost economics is a theoretical framework that can be used to explain or predict firm boundaries.
Examining transaction costs enables managers to see if it is cost-effective for the firm to expand boundaries via diversification or vertical integration. In other words, transaction costs help a firm to make ‘make or buy’ decisions.
When the costs of pursuing an activity in-house are less than the costs of transacting for that activity in the market, firms should vertically integrate.
Determining firm boundaries in a way that creates a sustainable competitive advantage, guided by transaction costs, is therefore a key challenge in corporate strategy.
Advantage of organizing economic activity within the firm
Ability to make command-and-control decisions among clear hierarchical lines.
It also allows for the coordination of highly complex tasks and specialized division of labour.
A company can also make transaction-specific investments that are highly valuable within a firm but are of little use to the external market.
An example of a transaction-specific investment would be a special machine that the firm only uses for the products of one buyer. Lastly, firms can create a community of knowledge.
Disadvantages of organizing economic activity within the firm
Disadvantages include administrative costs because of bureaucracy, the low-power of incentives such as hourly wages and salaries, and the principal-agent problem. You likely have heard of the principal-agent problem before.
An agent (or manager) performs activities on behalf of the principal (or owner/shareholder). However, the manager is likely to pursue their own interests.
Because separation of ownership and control is mandatory in public firms, the principal-agent problem is inevitable. Manager goals, such as job security, might therefore interfere with principal goals, like shareholder value.
Advantage of organising economic activity through markets
Firstly, markets have high-powered incentives, which can be powerful motivators.
Entrepreneurs can start their own venture and capture more profit than they would by being employed at a firm. For example, being acquired or doing an IPO (initial public offering) are known as liquidity events that provide enough money for life.
Markets also have increased flexibility - transacting in the market allows comparison of prices.
Disadvantages of organising economic activity through markets
The disadvantages include search costs, as a firm has to look for reliable suppliers. Firms also have to look out for opportunism by other parties - as partner firms may be wholly self-interested.
Another threat is incomplete contracting. All contracts are incomplete because they cannot fully include all future contingencies (and certain aspects like quality are hard to specify). This means that even with a contract, you never have full control over your dealings with the partner.
Another thing to look out for in markets is information asymmetry. This is when one party in a deal has more information than the other. Often, sellers have more information than buyers, which can lead to a crowding out of all “good” products.
Alternatives on the make-or-buy continuum
- Short-term contracts. With these, the firm sends requests for proposals (RFPs) to several companies, which initiates competitive bidding for contracts.
This allows for a longer planning period than individual market transactions and lower prices due to competitive bidding. However, firms have no incentive to make transaction-specific investments since the contracts are short. - Strategic alliances. These are voluntary arrangements between firms involving the sharing of knowledge, resources, and capabilities with the intent to develop processes or products. Alliances can facilitate investments in transaction-specific assets, without the transaction costs associated with owning firms in different stages of the industry value chain.
There are 3 different types of strategic alliances
- Long-term contracts. These have a duration longer than a year and facilitate transaction-specific investments. Examples include licensing, which enables firms to commercialize a patent, and franchising, which is when a franchisor grants a franchisee the right to use the franchisor’s trademark and processes. For this right, the franchisee pays a lump sum to the franchisor and part of their revenue.
- Equity alliance. This is when one partner takes partial ownership of another partner. This equity investment means a greater commitment to the partnership and can allow one company to get an inside look into another company. One partner can also pressure another into lowering prices. Additionally, it could encourage the firm to make a credible commitment, which is a long-term strategic decision that is hard to reverse.
- Joint venture. This is when two or more partners create and jointly own a new organization. Once again, because this is a long-term commitment, the firm is more inclined to make transaction-specific investments.
The last option on the make-or-buy continuum
Parent-subsidiary relationship. This is when a corporate parent owns a subsidiary and can direct it via command and control.
Transaction costs can arise in this relationship due to political turf battles, such as certain departments claiming their services are more valuable than other departments. It could also cause conflict with the amount of centralization of subsidiaries.
Vertical integration along the industry value chain
Vertical integration can be measured by the value that a company adds. This can be seen by looking at the industry value chain, which depicts the transformation of raw materials into finished goods through different stages.
Each stage represents a distinct industry where numerous firms are competing. An example of a stage would be raw materials, or marketing and sales.
There are varying levels of vertical integration
Most firms only focus on a few stages or one stage in the chain. However, some firms are fully integrated. This means they control the whole value chain. This allows for economies of scale, which creates lower costs, more operational efficiency through coordination, and better quality control.
However, it also means that the firm has to deal with many competitors at every stage. Other firms have low integration. This is because not all the value chain stages are equally profitable.
We can split vertical integration into two type
- Backward integration involves moving ownership of activities upstream to the originating inputs of the value chain.
- Forward integration involves moving ownership of activities closer to the end customer.
Benefits of vertical integration
The benefits of vertical integration include lowering costs, improving quality, facilitating scheduling and planning, securing critical supplies and distribution channels, and facilitating investments in specialized assets.
Specialized assets are unique assets that have high opportunity costs, offering a lot more value in their intended use than in their next-best use. These high opportunity costs come from the threat of opportunism. To overcome this threat, companies can undertake backward vertical integration.
Different types of specialized assets
- Site specificity: the assets have to be co-located;
- Physical asset specificity: assets whose physical properties are designed to satisfy a certain customer;
- Human asset specificity: investments made in human capital to acquire unique knowledge
and skills. An example of this could be training employees to master the routines of the employer.
Risks of vertical integration
Risks of vertical integration include increasing costs (in-house suppliers have higher costs due to exposure to market competition), reduced knowledge, reduced flexibility, and the increasing potential for legal repercussions. For example, trade authorities might accuse you of monopolizing an industry.
