The Vertical boundaries of the firm

1. The Vertical Boundaries of the firm By A.V. Vedpuriswar

2. The vertical boundaries of the firm • Production of a good/service involves many activities • Vertical chain – activities starting from acquisition of raw materials to the distribution of finished goods. • - Vertical boundaries • - What should be done in house? • - What should be purchased? • - Vertical integration decisions • - Make • - Buy • - Form alliances

3. Key issues in Vertical integration Technical efficiency meansuse of the least cost production process. Agency efficiency means exchange of goods and services in the value chain to minimise coordination, agency and transaction costs. The market is superior for minimising production costs. Vertical integration is superior for minimising transaction costs. Optimal vertical integration minimises the sum of technical and agency inefficiencies.

4. Make – Buy fallacies • - Do not outsource the asset if it is a source of competitive advantage • - Buy to avoid the costs of making the product • - Make to avoid paying profit margins to independent firms • - Make to avoid being fleeced by buyer during times of excess demand/ scarce supply

5. The case for Buy • - Exploiting scale and learning economies • - Market firms can often perform more efficiently • - They may have deep technical/managerial expertise or proprietary methodologies • - They might be able to aggregate the needs of many firms and generate economies of scale. • - They might leverage their experience in doing the same activity for different firms.

6. Agency costs • - Cost centres are insulated from competitive pressures • - Absence of market competition, difficulties in measuring divisional performance, make it difficult to judge efficiency, identify slack • - Even when a firm is aware of agency costs, it may find it difficult to eliminate them.

7. Influence Costs • - Firms allocate financial and human resources through internal capital markets • - If internal capital is scarce, when resources are allocated to one division, fewer resources are available to others • - Influence costs include the time spent on lobbying and the costs of bad decisions that arise from influence activities.

8. Other considerations - The more the ability of outside specialists to take advantage of economies of scale and scope, the weaker the case for vertical integration - Key questions :Are huge upfront set up costs involved? Is there a large market outside the firm? - If the answers are yes, market exchange is preferable to vertical integration.

9. Product market scale and growth • - A large scale and scope of operations strengthen the case for vertical integration. • - The more the firm produces and stronger the growth in demand, the more likely that inhouse input production can take advantage of economies of scale and scope than an outside specialist. • Asset specificity • - A firm gains more from vertical integration when production of inputs involves investments in relationship specific assets. • - Greater applications engineering effort is likely to involve greater human asset specificity. • - More complex components may be made internally, when the item being purchased is complex or it is difficult to measure performance and contracts become more difficult to write.

10. The case against Buy • Transaction costs • It is difficult to frame and enforce complete contracts • .Difficulties in visualising all possibilities • Difficulties in specifying / measuring performance • Asymmetric information • Reluctance to pursue litigation in view of costs involved • Adverse consequences of opportunistic behavior

11. Relation specific assets • When a transaction involves relation specific assets, switching trading partners is not easy. • Relation specific assets give rise to quasi rents. • Quasi rent equals the extra profit a firm gets when it deploys its relationship specific assets in their intended use and the transaction goes ahead as planned as opposed to deploying those assets in their best alternative use. • When a party has quasi rents, it can be held up by its trading partner. When this happens, the trading partner transfers some of the quasi rents to itself.

12. The potential for holdup raises the cost of market transactions • by making contract negotiations more contentious • by inducing parties to invest in safeguards to improve post contractual bargaining positions, • by engendering distrust and • by leading to under investment in relationship specific assets. • Hold up is especially tempting when contracts are highly incomplete, so that proving breach of contract is difficult.

13. Coordination issues • Contracts may not always ensure proper coordination • Costs of poor coordination can be high • Trading partners may be reluctant to develop and share valuable information • Leakage of private information • Production know how, design, consumer information • May give firms an advantage in the market • Contracts may not be effective in preventing leakage of info if the goods are “brought”, not “made”

14. Relationship specific investment I = Investment, P* = Captive (contracted) price Pm = Market price C = Variable cost Q = Output I + (Pm – C) Q = relationship specific investment Rent = Q (P* - C) – I Quasi Rent = Q (P* - Pm)

15. Case examples

16. Pepsico & its bottlers • Initially, PepsiCo was primarily a syrup manufacturer, purchasing raw materials purchased from the market and using independent firms to bottle and distribute the product • But over time Pepsi has consolidated distribution and marketing • Changes in the technology of bottling have created economies of scale • Emergence of national retailers like Wal-Mart created the need for a sophisticated centralized sales information system. • Sophisticated advertising and promotion campaigns demanded national coordination and the cooperation of bottlers • For better coordination, Pepsi bought out many of the bottlers .Pepsi bottling group controlled over 60% of worldwide bottling operations by 1990 • In 1989, Pepsi spun off the Pepsi bottling group but retained a 40% stake thereby retaining defacto control.

17. Floating power plants • Suppliers may be reluctant to make investments with a high degree of specificity. Once these investments are made, they tend to get locked in. • But there are creative solutions to the problem. • Take the example of power plants. • Manufacturers have eliminated geographic asset specificity by building power plants on floating barges. • Innovations have reduced the size and increased the reliability of gas turbines, making it possible to house large-capacity generators on a small number of barges. • Floating power plants can also be assembled off site and then towed to the purchasing nation. • This lowers labour costs so that manufacturers do not have to pay their skilled workers to go to a distant site for a long time.

18. Li & Fung • Hong Kong based trader • Has a network of suppliers across Asia • Tightly controls design and marketing • Manufacturing at cheaper locations • Works closely with vendors and helps them to cut costs • Globally dispersed value chain • Optimal blend of company involvement and vendor independence

19. Other examples • Reliance • Maruti • Tata Steel • Visakhapatnam Steel Plant • Asian Paints • Hindalco • Infosys

20. Hybrid alternatives • Between making and buying, there are intermediate alternatives: • Tapered integration • Strategic alliances and joint ventures • Keiretsu

21. Tapered integration • - Mixture of vertical integration and market exchange • - Produce part of the item and buy remaining quantity • - Expands capacity without having the need to make huge capital investments • - Use information about costs and profitability to negotiate with external vendors. • - Develop internal input supply capabilities to protect itself against hold up by independent input suppliers • - But may lead to • lack of scale • coordination/monitoring issues • retention of inefficient internal capacity

22. Strategic alliances and joint ventures • Strategic alliance • - Two or more firms collaborate on a project to share information or productive resources • Joint venture • - A type of strategic alliance in which two or more firms create and jointly own a new independent organization. • Alliances may make sense under the following conditions: • - There are impediments to comprehensive contracting. • - Relationship specific assets are involved and the two parties may “hold up” each other. • - All the expertise needed may not be available with one party. • - Market opportunity that creates the need for the transaction is transitory. • - There are clear roles for the two partners that may be difficult to combine in one.

23. Keiretsu • Japanese firms do not organize the vertical chain through arm’s length contracts. • They depend on a complex network of long-term, semi formal relationships. • There is a much higher degree of collaboration between the manufacturer and sub contractors. • Keiretsus involve more formalised institutional linkages. • Firms exchange shares and exchange board positions. • Each member of the Keiretsu believes that it will be the first choice of another Keiretsu member in future business dealings. • Keiretsu members do not take advantage of temporary demand surges. They also closely involve themselves in decision making. • Implicit contracts / long term relationships • - Implicit contracts are not enforceable in court • - A powerful mechanism that makes implicit contracts viable is the threat of losing future business if one party breaks the implicit contract for its own gain.