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Corporate Development (Subject) / Vertical Boundaries of the Firm (Lesson)

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• Sum up the vertical chain Begins with the acquisition of raw materials Ends with the sale of finished good/service Includes support services such as finance and marketing Part of business strategy
• Forward integration occurs when a firm moves into distribution or additional finishing work
• backward integration occurs when a firm begins to produce its own inputs
• outsourcing Movement away from vertical integration Buy services/goods on spot markets Contracting with suppliers
• why are some activities outsourced and others are not? Firms need to define their vertical boundaries Compare costs of using the market versus making activity in-house Considerations such as: Economies of scale, market competition, ease of coordination of production flows, private information, transaction costs of dealing with market firms
• Economies of scale - General concept when marginal cost is less than average cost Average costs decline as fixed costs are spread over larger volumes U-shape implies cost disadvantage for very small and very large firms
• Economies of scale - General concept when marginal cost is less than average cost Average costs decline as fixed costs are spread over larger volumes U-shape implies cost disadvantage for very small and very large firms In reality closer to L-shape Minimum efficient Size (MES) beyond which average costs are identical across firms
• Diseconomies of scale - general concept Beyond a certain size, bigger may not always be better Increasing labor costs ( bureaucracy effects scarcity of specialized resources "conflicting out"
• On what does the decision depend on make-or-buy problem The costs and benefits of using the market as opposed to performing the task in-house
• Economies of scope - general concept Firm 1 makes A and B, Firm 2 only A. If 1 makes A for smaller cost, it has economies of scope. Production of B reduces incremental cost of A! Common expression that describes strategies that exploit the economies of scope: Leveraging core competencies Competing on capabilities Mobilizing invisible assets Conflicting brand images may cause diseconomies of scope
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• Learning curve - general concept Learning economies are distinct from economies of scale Depend on cumulative output rather than the rate of output Learning leads to lower costs, higher quality and more effective pricing and marketing Slope of the curve is the relative size of the averag cost when cumulative output doubles Flattens out over time to become 1.0 expand output rapidly to benefit from learning curve and achieve a cost advantage may lead to losses in the short term but ensure long term profitability
• Transaction costs - general concept Costs of the execution of exchange relationships (Costs of using the price mechanism, costs of running the economic syste) External TAC (Initiation Costs, Bargaining Costs, Control Costs, Implementation Costs, Costs of adjustment) Internal TAC (Organization Costs, Coordination and agency costs within a company
• Reasons to "Buy" Market firms may have patents/proprietary information that makes low cost prosuction possible Market firms can achieve economies of scale that in-house unit cannot Market firms are subject to market discipline, whereas in-house units may hide inefficiencies behind overall success (Agency and influence costs)
• Agency costs The incentives to be efficient and innovative are weaker when a task is performed in-house Agents may be shirking/slacking and there may be costs of monitoring, measuring, implementing appropriate incentive shemes Performance measuring difficult due to independability problem and controllability problem or multitaksing
• Influence Costs In addition to agency costs, in-house also leads to influencing costs Allocate scarce capital Allocation can be favorably affected by influence activities More likely in large vertically integrated firms
• Reasons to "Make" Costs imposed by poor coordination Reluctance of partners to develop and share valuable private information TAC than can be avoided by performing task in-house
• Economic foundations of Contracts Firms often use contracts if certain tasks are performed outside the firm define the conditions of exchange list set of taks the remedies if one party fails to fulfill obligation firms do not completely trust  contracts are supposed to protect parties from opportunistic exploitation
• The role of Contract Law Facilitates transaction with incomplete contracts parties need not specify provisions that are common to a wide class of transactions
• Factors preventing complete contracting Bounded rationality (limited capacity to process information, deal with complexity, pursue rational aims Difficulties in specifying/measuring performance (terms like normal wear, costly measuring, difficult performance measuring) Assymetric information (no equal access to information, misinterpretation of information, Hidden information and action
• Reciprocity Potential fraction of the people exhibit social preferences Reciprocal preferences are contingent social preferences (behavior depends on the behavior of the person with whom one interacts) respond kindness with kindness expect same behavior from others
• Coordination problems For successful coordination, on party needs to make decisions that depend on the decisions made by others Dimensions of good fits: Timing, Size, Color, Sequence etc. Without good coordination, bootle necks arise important when design attributes are present Contracts that specify delivery dates, design tolerances etc.
• Make versus Buy - Reasons to make Costs imposed by poor coordination Reluctance of partners to develop and share valuable private information Transaction costs that can be avoided by performing the task in-house
• Leakage of private information and outsourcing Firms do not want to compromise the source of their competitive advantage Well-defined patents may help to protect no compete clause may prevent leakage of information
• Reasonst to make - Transaction costs market mechanism improves efficiency Costs of using the market that are saved by centralized direction Outsourcing entail costs of  negotiating, writing and enforcing contracts Costs are incurred due to opportunistic behavior of parties TC explain why economic activities outside the firm exist
• Some Make-Or-Buy fallacies rather make than  buy what gives you competitive advantage Outsourcing an activity eliminates the cost of that action backward integration captures the profit margin of the supplier and insures agains the risk of high input pricing Tie up distribution channel in order to deny access to the rivals, gain market share at the expense of rivals
• Fallacies - rather make than buy competitive advantage asset Wrong believe in what is acutally the competitive advantage it turns out that asset is easily available in the market New evaluation of competitive advantage
• Fallacies - Outsourcing an activity eliminates the cost of that activity doesnt matter since supplier also charges the firm with the associated costs the relevant consideration is whether it is more efficient to make or buy
• Recent trends in outsourcing Global competition New production technologies New information communictioins technology excess capacity
• Different forms of specificity Site specificity Physical asset specificity Dedicated assets Human asset specificity
• Hold-up problem Relation-specific assets are made to support a specific transaction they cannot easily redeployed for another transaction costlessly locked into the relationship
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• Site specificity located in close proximity to economize on transportation costs and inventory costs and to improve process efficiency
• Physical asset specificity Physical assets may have to be designed specifically for the particular transaction
• dedicated assets some investments are made to satisfy a single buyer, without whose business the investment will not be profitable
• Human asset specificity relationship-specific skills know-how  information of some of the employees
• the fundamental transformation according to O. Williamson Before: relationship-specific investmen is made firm has several potential trading partners afterwards profits will be determined by bilateral bargaining
• rent and quasi-rent rent: denotes economic profit you expect to make if all works out as planned - profits after all the economic costs quasi-rent: excess economic profit from a transaction compared with economic profits available from an alternative transaction that provides you with next best profit
• Relationship-specific investment for 1.000.000 units I - 1.000.000 (Pm-C) Pm = open market price C variable cost l loan (fixed costs) The amount you cannot recover if the factory does not sell to the specific relationship
• Cooperation in a repeated game With an infinite horizon cooperation is profitable when C+C/r > D + P/r
• The Holp-up problem raises the cost of transacting exchanges contract negotiations become more difficult investments may have to be made to improve ex-post bargaining position potential hold-up can cause distrust there could be underinvestment in relation specific assets
• Potential for hold-ups lead to Underinvestment in these assets investment in safeguards reduced trust
• Diferentiation in the degree of vertical integration across industries across firms within an industrie across transactions within a firm
• The trade-off in vertical integration Using the market improves technical efficiency (least cost production) Vertical integration improves agency efficiency (coordination, transaction costs) Firm should economize - choose the best possible combination of technical and agency efficiency
• Important terms in the context of technical efficiency for vertical integration Least-cost production process power of market discipline Specialized assets make the firms economies of scale weaker
• Three ways to organize a transaction in the vertical chain the two units are independent (non integration) Upstream unit owns the asset of the downstream unit (forward integration) Downstream unit owns the assets of the upstream unit (backward integration)
• Decision making for integration or not if the investments by the upstream player and the downstream player are of comparable importance, market exchange is preferred if the investments by one player is more important in value creation, vertical integration is preferred

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