Vertical integration

1. Vertical integration When does outsourcing/ownership matter?

2. What is vertical integration? Vertical (or horizontal) integration means that the assets that were previously held by two firms are combined into a single firm. The result is either joint ownership or the sale of one firm�s assets to the other.

3. Market Imperfections Upstream and downstream firm Downstream firm Monopolist with no costs Sets price to its market (mark-up over marginal costs) Upstream firm Monopolist Sets input price to downstream firm anticipating impact on demand

4. Vertical Integration Suppose upstream and downstream firms are commonly owned Best internal transfer price is based on upstream marginal cost, c. Market price set so that MR = c. Maximises joint profits

5. Impact on Profits

6. Double Marginalisation With outsourcing Both firms charge a mark-up Higher prices, low overall profits, lower consumer welfare (not very competitive if there is another vertical chain) Solved by: Vertical integration Two-part tariffs More downstream or upstream competition

7. Can vertical integration matter? The Coase Theorem tells us that asset ownership does not matter for efficiency. Assumes complete contracting When contracts are incomplete there exist residual rights of control (unspecified actions). According to Grossman & Hart: �To the extent that there are benefits of control, there will always be potential costs associated with removing control (i.e., ownership) from those who manage productive activities.�

8. GM-Fisher Body 1920s: General Motors purchased car bodies from independent firm (Fisher Body) Technology change: wooden to metal GM built a new assembly plant that required reliable supply wanted Fisher Body to build a new car body plant next to it no need for shipping docks etc.

9. Fisher Refused Fisher Body refused to make this investment. Feared that a plant so closely tailored to GM�s needs would be vulnerable to GM�s demands (hold-up) Eventually resolved this issue by vertical integration -- could not find a contractual solution

10. Merger Benefits & Costs Benefits to GM: Could make more demands of Fisher Body More investment or extra supply Costs to GM: Diminished managerial incentives If costs are lowered in the body plant, GM is better able to appropriate these at expense of managers. Harder to keep those costs down.

11. Bottling Pepsi PepsiCo has two types of bottlers: Independent: owns assets of bottling operation and exclusive rights to franchise territory. Can determine how these are used - when to restock stores etc. Company owned: decisions can be made higher up; Pepsi can choose to delegate local marketing to its subsiduary

12. Pepsi�s Control Pepsi cannot control how an independent bottler operates in a territory If it wants a national marketing strategy (such as the Pepsi Challenge), it can�t compel the bottler to cooperate By acquiring a bottler, Pepsi has ultimate control. If the subsidiary managers refused to participate in the national campaign, they could be sacked and replaced.

13. Motivating Example Again Service requires a truck (the asset) for production Also, enhancing value are: a shipper, S (who wants to ship goods) there are also other shippers except that they have goods to ship that are $100 less in value created a trucker, T (does this): can take care or no care in maintaining truck; there are many truckers who can take no care but this particular trucker is the only one that can take care Effort in care is relationship-specific and is now assumed to be non-contractible Also assume that care is a skill that is developed (through habits etc.). Therefore, it becomes embedded in the trucker�s human capital.

14. Effort and Value Benefit from extended truck life No Care: truck�s value is $50 Care: truck�s value is $200 Trucker�s effort cost of care Minimal care: cost of $0 High care: cost of $100 Marginal Benefit = $150 > $100 = Marginal Cost Efficient to take care What happens under different ownership structures for the asset?

15. Non-contractible Investment Suppose bargaining took place after effort choice is made There are four cases to evaluate. Minimal care and alternative shipper Minimal care and S High care and alternative shipper High care and S S is no longer essential and so their added value is less than the T if they do not own the asset.

16. Will trucker take care?

17. Incentives and Ownership Trucker can be easily replaced if does not take care. However, under BI and 3rd party ownership (vertical separation), does not expect to earn enough to cover costs of $100. Will take care under FI: needs to have control rights (i.e., right to exclude use of asset) in order to gain sufficient surplus ex post. That is, under FI, by taking care, T gets $50 (=$150-$100) but only $25 if it does not take care. Under Cooperative, taking care gives T $0 but not taking care gives them $25. General principle: give control rights to agents making important investments.

18. Efficient Integration Level As they encourage the trucker to take care, forward integration is the only efficient organisational form Do we expect asset ownership to track efficiency?

19. Shipper Interests Shipper might choose to have a back haul. A back haul adds value of $100 (independent of level of care). Suppose that trucker � if they own the truck � can find alternative customers for the back haul. If expend cost of $10 will find alternative customer adding value of $50.

20. Forward Integration Shipper�s added value ex post: $250 if trucker searches for alternative customer $300 if trucker does not search Trucker�s added value ex post $300 regardless of whether searches Searching improves trucker�s expected surplus from $150 to $175; therefore, worth the $10 expense. If search very costly, BI may become efficient again.

21. Optimal Firm Boundaries Ownership provides maximal incentives to take non-contractible actions Optimal firm boundary depends upon: whose actions are hardest to encourage whose actions are most important for value Never vest ownership with someone who does not provide a non-contractible action (I.e., 3rd party)

22. What Happens in Trucking? Suppose that you could put on-board computers on truckers to monitor drivers. Theory: easier to monitor driver�s care and reflect it in explicit performance payments or fines � therefore, less need for trucker ownership. Baker & Hubbard (2000): use of OBCs has increased non-trucker ownership especially on routes that may be more subject to trucker rent seeking.

23. Shipper vs. Carrier ownership What determines whether shippers use internal (captive) fleets or for-hire carriers for a haul? Determines who owns control rights associated with dispatch (truck scheduling) Shippers use internal fleets when want high service levels from truck drivers Truck utilisation higher in for-hire fleets � ability to line up a sequence of hauls for a truck � tight coordination (requires dispatcher effort) Need for flexibility conflicts with search for back hauls Harder to motivate truck drivers when looking for high service levels. Empirically: OBCs lead to more shipper ownership

24. Case: Insurance Industry Insurance industries In-house sales force: whole life Independent brokers: fire and casualty Choice determines ownership of client list

25. Effect of ownership Agent owns list cannot be solicited without permission agent looks for clients most likely to renew motivate agents by using renewal commission agent can hold-up company; threaten not to introduce new products to clients Company owns list company can hold-up agent; threaten to increase premiums that reduce renewal commission

26. Applying Grossman & Hart Choice between independent and in-house agents should turn on relative importance of investments in developing long-term clients by the agent and list-building activities of the insurance firm Whole life: customer less likely to switch so searching for long-term customers less important -- in-house Fire & casualty: searching for long-term customers is important -- independent

27. Dynamic Issues How does outsourcing and integration performance change over time?

28. T5 at Heathrow Project management handled internally Contractors on cost-plus contracts (not fixed price as is usually the case) British Airports Authority wanted to keep options open to change design specifications throughout the life of the project Happy to engage in on-going managerial attention

29. Fixed vs Cost Plus Fixed contracts Costs aren�t passed through High powered incentives to keep costs down Anticipate cost savings that might be achieved when tendering But contracts incomplete: so subject to renegotiation (also anticipated in tender) Cost plus contracts Costs are passed through Low powered incentives No difficult renegotiations � easier to change designs during project For complex projects that require lots of coordination, may be better to use cost plus contracts

30. Car Manufacturing Varied patterns of outsourcing Some companies integrated (GM) Some outsource almost everything (Volvo) Novak-Stern case studies suggest that... External sourcing allows firms to access state-of-the-art technology but leaves them open to hold-up and low effort supply after the initial terms of the contract are satisfied Internal development is associated with inferior technology development and high costs for an initial model-year, but there are much greater opportunities for improvements over time

31. Performance Over time

32. Empirical Findings

33. Summary No black and white choice in outsourcing Capabilities can improve over time Ability to coordinate internal or external teams Ability to improve internal performance Handling contractual disputes No �one size fits all� Complexity � design and parts

34. Principles of Efficient Ownership Simple example Asset: luxury yacht Service: gourmet seafare Workers: chef and skipper Customer: tycoon Value created Tycoon value = $240 (no other customers) Substitutes for skipper�s skills (no added value) Chef: asset-specific action (no other yachts) for cost of $100; necessary to provide service for Tycoon Time-line Date 0: chef chooses whether to take action Date 1: negotiate over division of $240

35. Ownership Outcomes

36. Skipper Value Now suppose, skipper has a non-contractible (date 0) action for cost of $100 can increase value of service to tycoon by another $240 (total now $480) for example, increases knowledge of local islands

37. Ownership Outcomes

38. Complementary Assets Now suppose there are other customers who can use the yacht But tycoon can choose a non-contractible action (e.g., plan entertainment schedule for the year). Gives additional value of $240. Yacht can be split in two: galley and hull

39. Divided Ownership Is it ever optimal for chef to own galley and skipper to own hull? Division of value is: chef ($320), skipper ($320) and tycoon ($240/3) Tycoon has to reach agreement with both while skipper and chef only require their joint agreement Better to give entire yacht to skipper or chef. Tycoon�s incentive rises ($240/2)

40. Principles Never give ownership to dispensable individuals Give ownership to indispensable agents (even though may not make an investment) Vest ownership of complementary assets with a single individual

41. Qualification Does asset ownership really improve incentives for specific investments? Those investments create value But may reduce the asset�s value outside of the relationship: it is specialised to the other agent Without ownership, do not care about this reduction Hence, it is possible that incentives could be reduced by ownership

42. Summary Value of ownership Increased bargaining position (added value) Incentives to take non-contractible actions Ownership improves this by allowing agent to capture a greater share of the rewards But diminishes the incentives of non-owners Who should own an asset? Agents taking non-contractible actions Important agents