Economics of Strategy

Economics of Strategy Besanko, Dranove, Shanley and Schaefer, 3rd Edition Chapter 4 Organizing Vertical Boundaries: Vertical Integration and its Alternatives Slide show adapted on basis of that prepared by Richard PonArul California State University, Chico  John Wiley  Sons, Inc.

Introduction • There are various approaches in considering the merits of vertical integration • balancing transactions costs (O. Williamson) • role of asset ownership (S.Grossman, O.Hart, J.Moore) These two approaches generate also two different theories of the firm • There are also alternatives to vertical integration • tapered integration • joint ventures • networks • implicit contracts

Vertical Boundaries • For each step in the vertical chain the firm has to decide between market exchange and vertical integration • The degree of vertical integration differs • Across industries • Across firms within an industry • Across transactions with in firm • We consider an upstream firm and a downstream firm

The Tradeoff in Vertical Integration • Using the market improves technical efficiency (least cost production) – it relates to production • Vertical integration improves agency efficiency (coordination, transactions costs) – it relates to exchange Firm should “economize” - choose the best possible combination of technical and agency efficiencies

Technical Efficiency • Using the market leads to higher technical efficiency compared to vertical integration (power of market discipline) • The difference in technical efficiency of market over vertical integration (T) depends on the nature of the assets involved in production (ie. production of the intermediate product by the upstream firm)

Technical Efficiency • As the assets become more specialized the market firm’s economies of scale become weaker • The difference in technical efficiency of market over vertical integration (T) declines with greater asset specificity

Agency Efficiency • At high levels of asset specificity, differential agency efficiency of market over vertical integration (A) is negative • When specialized assets are involved, potential for a holdup is high and the result is higher transactions costs

Agency Efficiency • At low levels of asset specificity, differential agency efficiency of market over vertical integration (A) is likely to be positive • Without the holdup problem, market exchange could be more agency efficient than in-house production (due to intra-firm agency and influence costs).

Efficiency Tradeoff • The combined (market over vertical integration) differential efficiency (C) will be negatively related to asset specificity • At high levels of assets specificity vertical integration is more efficient • At low levels of assets specificity outsourcing wins

DT > 0: internal production costs are never lower than external - economies of scale If the input is purchased from an outside supplier agency costs include negotiation, writing and enforcing contracts If the input is sourced internally agency costs are the agency and influence costs discussed before Vertical integration is preferable when economies of scale are weak and asset specificity is high An illustration k measures asset specificity $ When the degree of asset specificity is low DA > 0 DT gives the difference in minimum production cost from internal versus external production When the degree of asset specificity is greater than k** vertical integration is the preferred mode When the degree of asset specificity is less than k** market exchange is the preferred mode When the degree of asset specificity is high DA < 0 DA gives the difference in agency costs from internal versus external production DT k** k* DC is the vertical sum of DT and DA. It is the difference between production and exchange costs with vertical integration and these costs with market exchange k When the degree of asset specificity is less than k* market exchange has lower transactions costs DC DA

Technical and Agency Efficiency

Efficiency Tradeoff and Scale • When the scale of production of the downstream firm increases, the vertically integrated firm enjoys better economies of scale • With increased scale, the differential technical efficiency decreases for every level of asset specificity (the T curve shifts downward)

Efficiency Tradeoff and Scale • With an increase in scale, the differential agency efficiency becomes more sensitive to asset specificity • Differential agency efficiency (market over vertical integration) will increase with scale for low asset specificity • With high asset specificity, differential agency efficiency decreases with scale → A curve twists clockwise through point k*

Efficiency Tradeoff and Scale • The combined differential efficiency (C) sharply declines for low asset specificity → C curves shifts downward and becomes less steep • The degree of asset specificity at which market is just competitive with vertical integration declines (from k** to k***) • Vertical integration is preferred to market exchange over a larger range of asset specificity

The illustration (cont.) An increase in market size reduces the critical degree of asset specificity above which vertical integration is preferred Now consider the impact of market growth on the internal/external choice $ An increase in market size causes DT to fall k*** An increase in market size accentuates the advantage of the mode of production with lower exchange costs and so twists DA around k* DT k** k* k The overall effect is to change DC and move k** to the left to k*** DC DA

Vertical integration (cont.) Three important conclusions • Scale and scope economies at intermediate input level • gain less from vertical integration when scale and scope economies are strong • Product market scale and growth • gain more from vertical integration in large and growing markets • Asset specificity • gain more from vertical integration when production involves investment in relationship-specific assets

Real-World Evidence • GM is more vertically integrated than Ford is, for the same asset specificity (scale) • In aerospace, greater design specificity increases the likelihood of vertical integration of production • Among utilities, mine-mouth plants are more likely to be integrated compared with other plants

The Virtual Corporation (Davidow-Malone, 1992) • Advances in technology have reduced coordination costs and reduced asset specificity • Consequently, the advantage of market over vertical integration has steadily increased • Virtual corporation is the limit when each element in the vertical chain will be independent

Vertical Integration and Asset Ownership Grossman-Hart-Moore (GHM) adopt a different approach to study vertical integration: • Make-or-buy decision is essentially a decision regarding ownership rights: if right of use is granted the owner retains residual rights of control (i.e.. Rights of control on what is not explicitly stipulated on the contract) cont.

Vertical Integration and Asset Ownership • If contracts were complete, it will not matter who owned the assets in the vertical chain • With incomplete contracts, ownership pattern determines the willingness of each party to make relationship-specific investments

Vertical Integration and Asset Ownership • Three ways to organize a transaction in the vertical chain • The two units are independent (non integration) • Upstream unit owns the assets of the downstream unit (forward integration) • Downstream unit owns the assets of the upstream unit (backward integration)

Asset Ownership and Integration • Possession of residual control improves bargaining power over operating decision • The form of integration affects the incentives to invest in relationship-specific assets • Whether vertical integration is optimal or not depends on the relative contribution to value added by each party’s investment

Asset Ownership and Integration • If the investments by the upstream player and the downstream player are of comparable importance, market exchange is preferred • If the investment by one player is more important in value creation, vertical integration is preferred

Asset Ownership and Integration • Asset ownership is an important dimension of vertical integration • There could be degrees of integration depending on the extent of control over specialized assets • Example: Auto manufacturers can use independent suppliers for body parts but own the dies and stamping machines

Vertical Integration in Insurance Industry • In whole life insurance, sales agents’ efforts in renewal are unimportant and insurers tend to use in-house sales forces and tend to own client lists • In term life insurance, renewal efforts are more important and independent agents who own client lists are used

Human Assets and Vertical Integration • When physical assets are involved, upstream (or downstream) asset ownership can be used along with market exchange • When human assets are important, acquiring control of these assets can be done only through a full fledged vertical integration

Process Issues in Vertical Mergers • The desirability of a vertical merger is affected by its impact on technical and agency efficiency • It is also affected by governance issues • managers of the acquired unit have to cede control post-merger • but they must be given decision-making power commensurate with their control over specialized resources e.g. human capital • decision-making rights should be given to managers with the greatest influence in performance and profitability • if success depends on synergies associated with physical assets, centralize • if success depends on specialized knowledge of acquired managers, decentralize

Process issues (cont.) • The governance structure that emerges may well exhibit path dependence • past circumstances determine governance structure • immediate post-merger conflict undermines the potential for future cooperation • affects relationship between parent and a spun-off unit • may maintain long-term informal association • affects capacity to sell outside the vertically integrated unit • internal division does not usually have this expertise: the external market is a distraction • an acquired supplier does have this expertise: it had marketing capacity prior to acquisition

Alternatives to Vertical Integration • Tapered integration (making some and buying the rest) • Joint ventures and strategic alliances • Long term collaborative relationships • Implicit contracts between firms

Tapered Integration • A firm may produce part of its input on its own and purchase the rest • A firm may sell part of its output through in-house sales efforts and sell the rest through independent distributors

Tapered Integration: Advantages • Additional input/output channels without massive capital investments • Information about costs and profitability from internal operations can help in negotiating with market firms (threat of self manufacture can discipline external channels) and external supplier can be a yardstick to control internal division. • Internal supply capabilities will protect against potential holdups

Tapered Integration: Disadvantages • Possible loss of economies of scale • Coordination may become more difficult since the two production units must agree on product specifications and delivery times • Managers may be self-serving in continuing with internal production well after it has become inefficient to do so

Tapered Integration in Gasoline Retailing • Major oil refiners sell through their own service stations and through independently owned stations • As gas stations have moved away from auto repair and maintenance services, the proportion of company owned stations are growing

Strategic Alliances and Joint Ventures • Alliances involve cooperation, coordination and information sharing for a joint project while the participating firms continue to be independent • A joint venture is an alliance where a new independent organization is created and jointly owned by the promoting firms

Strategic Alliance • Alliances and joint ventures are intermediate solutions, between market exchange and vertical integration • Rather than rely on contracts, an alliance relies on trust and reciprocity • Disputes are rarely litigated but resolves through negotiation

Strategic Alliance – Advantages Transactions that are natural candidates for alliances have compelling reasons to both make and buy: • Uncertainty surrounding future activities prevents the parties from going into the specifics of those decisions in a contract • Transactions are complex and one cannot count on contract law to “fill the gaps” • Existence of relationship-specific assets and potential holdup problem

Strategic Alliance - Advantages • Any one party does not have the expertise to organize the transaction internally • Market opportunity that induced the transaction is not expected to last very long making a long term contract or merger unattractive • Regulatory environment necessitates acquiring a local partner for the venture

Strategic Alliance - Costs There are drawbacks • risk of leakage of information and loss of control of proprietary information • the alliance usually requires extensive information sharing between independent firms • efficient coordination may be difficult to achieve • no formal mechanism for resolving disputes • suffers from agency and influence costs • effort split across independent firms • potential free-rider problem: neither party has the incentive to monitor effectively because they not not keep all the benefits

Collaborative Relationships • Japanese industrial firms appear to be smaller and less vertically integrated compared to their western counterparts • Japanese firms organize the vertical chain using long term collaborative relationship among firms rather than arm’s length transactions

Collaborative Relationships • Two major types of collaborative relationships are found in Japan • Subcontractor networks • Keiretsu

Subcontractor Networks • Japanese manufacturers maintain close, informal, long term relationship with their network of subcontractors • The typical relationship between a manufacturer and a subcontractor involves far more asset specificity in Japan than in the West Example, UK vs Japan in electronics: • short-term, narrowly defined • mediated by contractual rather than informal arrangements

Keiretsu • Member firms of a keiretsu hold each other’s equity • Links among firms are further strengthened by personal relationships among top executives • Most of the key activities in the vertical chain are performed by members of the keiretsu with easy coordination and no chance for holdups

Keiretsu Formal, institutionalized relationship with complex linkages Other financial institutions Life insurance companies Banks Loans Trading Companies Manuf’g Companies Equity holdings Trade Satellite Companies

Implicit Contracts • Implicit contracts are unstated understanding between firms in a business relationship • Longstanding relationship between firms can make them behave cooperatively towards each other without any formal contracts

Implicit Contracts • The threat of losing future business (and the future stream of profits) is enough to deter opportunistic behavior in any one period • The desire to protect one’s reputation in the market place can be another mechanism that makes implicit contracts viable

An illustration Should commitment be reduced? Upstream Supplier Downstream Firm Final Consumers Stick with the implicit contract so long as r < 50% Profit p.a. $1 million Profit p.a. $1 million Both parties have alternative trading partners with profits of $900,000 p.a. if forced to switch Gain: one-off increase of $200,000 Both parties can increase profits to $1.2 million by reducing commitment to the relationship Loss: long-term loss of $100,000 from collapse of relationship Present value of loss = $100,000/r

Economics of Strategy