Vertical Scope of the Firm

1. Vertical Scope of the Firm What are the appropriate (efficient) organizational boundaries of the firm?

2. Transaction Costs and the Scope of the Firm • In relation to each dimension of scope, the basic issue is relative efficiency of the single firm compared with several specialist firms. • Common Issue: What are transactions costs of markets compared with administrative/governance costs of the firm? • Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 VERTICAL PRODUCT GEOGRAPHICAL AREAS V1 V2 V3 P1 P2 P3 SINGLEFIRM A1 A2 A3 V1 SEVERAL SPECIALIZED FIRMS P1 P1 P1 A3 A1 A2 V2 V3

3. Creating Efficiently Designed Corporations • The corporate hierarchy will be efficient when it can be shown to be the organizational arrangement that minimizes the sum of production and governance costs. Production costs are the direct costs incurred in the physical production and exchange of the item subject to the transaction. Governance costs include costs of negotiating, writing, monitoring, enforcing, and possibly also bonding to the terms of the organizational arrangement. • Historically, production costs were the primary drivers of firm boundaries. More recently, attention has been placed on governance costs. • Source: Collis and Montgomergy, Corporate Strategy, 1997

4. Defining Vertical Integration • Vertical integration (VI) is a firm’s ownership of vertically related activities. • Vertical integration can occur in 2 directions: • Backward Integration (producing own inputs) • Forward Integration (disposing of own outputs) • Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

5. Benefits of Vertical Integration • Economies of combined operations • Economies of internal control and coordination • Assure supply or demand • Better quality control and coordination • Protect proprietary technology • Gain access to information • Avoid costs of dealing with the market • Gain (or offset) market power • Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

6. The Costs of Vertical Integration • Differences between stages in optimal scale of operation • Managing strategically different businesses • Agency costs • Higher capital investment • Reduced Flexibility • in responding to demand uncertainty • in responding to changes in technology, customer preferences, etc. • Foreclose access to outside information/technology • Dulled incentives • Costs of bureaucratic hierarchy • Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

7. Benefits of the Market • Informational efficiencies i.e. price mechanisms and decentralized decision-making • Powerful incentive mechanisms i.e. better alignment self-interested behavior and incentives • Source: Collis and Montgomery, Corporate Strategy, 1997 e.g.Direct production costs of individual proprietors transacting with one another on the market will be lower than those involving employees inside a corporate hierarchy.

8. Costs of the Market: Transaction Costs and Market Failures • Market relationships fail when they are subject to: • Opportunism (lying, cheating, stealing, acting self-interestedly) • Asset specificity (small numbers) (Location specificity, physical asset specificity, and human asset specificity) • Uncertainty (inability to predetermine all future eventualities) • High Frequency (repeated exposure to hold up) • It is the possibility of firms acting opportunistically that causes market failure. The other three conditions create the opportunity for a firm to act opportunistically. • Other Sources include resource inseparability, information impactedness, and market power • Source: Collis and Montgomery, Corporate Strategy, 1997

9. The Choice between Market and Hierarchy MARKET HIERARCHY Informational Efficiencies High-Powered Incentives Authority Coordination BENEFITS Transaction Costs Market Power Bureaucracy Agency theory COSTS Source: Collis and Montgomery, Corporate Strategy, 1997

10. How many firms are there in the The fewer the companies, the greater vertically related activity? the attraction of VI. Do transactions-specific investmentsThe greater the requirements for need to be made by either party? specific investments, the more attractive is VI. Does limited availability of informationThe greater the difficulty of specifying provide opportunities to the contracting and monitoring contracts, the greater firm to behave opportunistically (i.e., the advantages of VI. cheat)? Are market transactions subject to taxes VI is attractive if it can circumvent and regulations? taxes and regulations. How much uncertainty exists with regard Uncertainty raises the costs of writing to the circumstances prevailing over the and monitoring contracts, and period of the contracts? provides opportunities for cheating, therefore increasing the attractiveness of VI. Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Factors that are important in determining the merits of vertical integration compared to market transactions

11. How uncertain is market demand? The greater the demand uncertainty-- the more costly is VI. Are the two stages similar in terms of The greater the dissimilarity in scale-theoptimal scale of operations? the more difficult is VI. How strategically similar are the different The greater the strategic dissimilarity stages in terms of key success factors the more difficult is VI. and the resources and capabilities required for success? Does VI increase risk through requiring The heavier the investment heavy investments in multiple stages requirements and the greater the and compounding otherwise independent risks at each stage--the independent risk factors? more risky is VI. Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Factors that are important in determining the merits of vertical integration compared to market transactions

12. Intermediate Forms of Organization: A Continuum of Governance Arrangements RANGE OF INTERMEDIATE FORMS SPOTMARKET INTERNAL HIERARCHY (full integration) LONG-TERM CONTRACTS STRATEGIC ALLIANCES JOINT VENTURES QUASI-VERTICAL INTEGRATION (PARTIAL OWNERSHIP) Intermediate relationships may combine the benefits of both market transactions and internalization

13. Different Types of Vertical Relationships Low Degree of Commitment High Low Informal supplier/ customer relationships Vertical integration Supplier/ customer partnerships Formalization Spot sales/ purchases Joint ventures Agency agreements Franchises Long-term contracts High Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

14. Designing Vertical Relationships: Long-Term Contracts and Quasi-Vertical Integration • Intermediate between spot transactions and vertical integration are several types of vertical relationships --such relationships may combine benefits of both market transactions and internalization • Key issues in designing vertical relationships -- How is risk allocated between the parties? -- Are the incentives appropriate? • Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

15. Recent Trends in Vertical Relationships (US) From competitive contracting to supplier partnerships(e.g. auto industry). From vertical integration to outsourcing(not just components, also IT, distribution, and administrative services). Diffusion of franchising. Technology partnerships (e.g. IBM-Apple; Canon-HP). Inter-firm networks. • General conclusion: Boundaries between firms and markets becoming increasingly blurred. • Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

16. JAPANESE APPROACH • Extensive use of subcontracting • Mitigate opportunism via: • equity links • personnel links • long-term relationships • implicit contracts • Close coordination of suppliers and assemblers • product design • JIT delivery • Source: Mari Sakakibara, UCLA, 1997

17. Flow Chart for Vertical Integration Decisions MARKET CONTRACT YES INCENTIVES AGENCY COSTS NO HOLD-UP TRANSACTION COSTS NO RENT APPROPRIABILITY TRADEOFF COORDINATION FIAT YES YES INSIDE HIERARCHY YES

18. Action Steps in Scope of Firm Decisions • Step 1: Disaggregate the Industry Value Chain • Step 2: Competitive Advantage • Do you have a competitive advantage in the performance of the activity? • Step 3: Market Failure • Is there a clear market failure? Are the costs of market governance extremely high? Can dominant firms exercise market power? • Step 4: Need for Coordination • Is there an ongoing need for intensive coordination? Are continual and integrated changes required? Is there a distinct interface between activities? • Source: Collis and Montgomery, Corporate Strategy, 1997

19. Action Steps (cont’d) • Step 5: Importance of Incentives • How high are agency costs inside the hierarchy? How much do worker skill and effort affect outcomes? Can an effective incentive scheme be designed? Which is more important: coordination or high-powered incentives? • Source: Collis and Montgomery, Corporate Strategy, 1997

20. Summary: Creating Value in Vertical Activities Be Better Than Competitors (1) In determining whether activities should be internal or external: Internal Activities External Customer External Supplier (2) In coordinating these activities along the value chain:

21. General Conclusion • Ross Perot to GM Management: • “You don’t need to own a dairy to buy milk.”