ECP 6701 Competitive Strategies in Expanding Markets

ECP 6701 Competitive Strategies in Expanding Markets Vertical Boundaries of the Firm

Readings • BDSS Chapter3

Vertical Chain • Begins with the acquisition of raw materials • Ends with the sale of finished goods/services • Includes support services such as finance and marketing • Organizing the vertical chain is an important part of business strategy

Vertical Boundaries of the Firm • Which steps of the vertical chain are to be performed inside the firm? • Which steps of the vertical chain to be out-sourced? • Choice between the “invisible hand” of the market and the “visible hand” of the organization (Make or Buy)

Make versus Buy • Decision depends on the costs and benefits of using the market as opposed to performing the task in-house • Outside specialists may perform a task better than the firm can • Intermediate solutions are possible (Examples: Strategic alliances with suppliers, Joint ventures)

Support Services • Accounting • Finance • Legal Support • Marketing • Planning • Human Resource Management

Defining Boundaries • Firms need to define their vertical boundaries • Considerations • Economies of scale achieved by market firms • Value of market discipline • Ease of coordination of production flows in-house • Transactions costs when dealing with market firms

Reasons to Buy rather than Make • Market firms (outside specialists) may have patents/proprietary information that makes low cost production possible • Market firms can achieve economies of scale that in-house units cannot • Market firms are subject to market discipline, whereas in-house units may be able to hide their inefficiencies behind overall corporate success (Agency and influence costs)

Economies of Scale

Economies of Scale • A given manufacturer of automobiles may not be able to reach the minimum efficient scale (A*) for anti-lock brakes • An outside supplier may reach the minimum efficient scale by supplying to different automobile manufacturers

Economies of Scale • An automobile manufacturer would rather buy anti-lock brakes from an independent supplier than from a competitor • Minimum efficient scale may be feasible for the independent supplier but not for an automobile manufacturer

Economies of Scale • Will the outside supplier charge c* (its average cost) or c’ (the average cost for the manufacturer for in-house production)? • The answer depends on the degree of competition faced by the supplier

Agency and Influence Costs • The incentives to be efficient and innovative are weaker when a task is performed in-house • Agency costs are particularly problematic if the task is performed by a “cost center” within an organization • It is difficult to internally replicate the incentives faced by market firms

Influence costs • In addition to agency costs, performing a task in-house will lead to “influence costs” as well • “Internal Capital Markets” allocates scarce capital • Allocations can be favorably affected by influence activities • Resources consumed by influence activities represent “influence costs”

Reasons to Make • Costs imposed by poor coordination • Reluctance of partners to develop and share valuable private information • Transactions cost that can be avoided by performing the task in-house • Each problem can be traced to difficulties in contracting

Role of Contracts • Firms often use contracts when certain tasks are performed outside the firm • Contracts list • the set of tasks that need to be performed • the remedies if one party fails to fulfill its obligation

Contracts • Contracts protect each party to a transaction from opportunistic behavior of other(s) • Contracts’ ability to provide this protection depends on • the “completeness” of contracts • the body of contract law

Complete Contract • A complete contract stipulates what each party should do for every possible contingency • No party can exploit others’ weaknesses • To create a compete contract one should be able to contemplate all possible contingencies • One should be able to “map” from each possible contingency to a set of actions • One should be able to define and measure performances • One should be able to enforce the contract

Complete Contract (Continued) • To enforce a contract, an outside party (judge, arbitrator) should be able to • observe the contingency • observe the actions by the parties • impose the stated penalties for non-performance • Real life contracts are usually incomplete contracts

Incomplete Contracts • Incomplete contracts • Involve some ambiguities • Need not anticipate all possible contingencies • Do not spell out rights and responsibilities of parties completely

Factors that Prevent Complete Contracting • Bounded rationality • Difficulties in specifying/measuring performance • Asymmetric information

Bounded Rationality • Individuals have limited capacity to • Process information • Deal with complexity • Pursue rational aims • Individuals cannot foresee all possible contingencies

Specifying/Measuring Performance • Terms like “normal wear and tear” may have different interpretations • Performance cannot always be measured unambiguously

Asymmetric Information • Parties to the contract may not have equal access to contract-relevant information • One party can misrepresent information with impurity

Contract Law • Contract law facilitates transactions with incomplete contracts • Parties need not specify provisions that are common to a wide class of transactions

Limitations of Contract Law • Doctrines of contract law are in broad language that could be interpreted in different ways • Litigation can be a costly way to deal with breach of contract • Litigation can be time consuming • Litigation weakens the business relationship

Coordination of Production Flows • For successful coordination one party needs to make decisions that depend on the decision made by others • A good fit should be accomplished in several dimensions. Some examples are: • Timing • Size • Color • Sequence

Coordination Problems • Without good coordination, bottlenecks arise in the vertical chain • Coordination is especially important when “design attributes” are present • To ensure coordination, firms rely on contracts that specify delivery dates, design tolerances and other performance targets

Leakage of Private Information and Outsourcing • Firms would not want to compromise the source of their competitive advantage • Well- defined patents can help but may not provide full protection • Contracts with non compete clauses can be used to protect against leakage of information • In practice non-compete clauses can be hard to enforce

Transactions Costs • If the market mechanism improves efficiency, why do so many of the activities take place outside the price system? (Coase) • Costs of using the market that are saved by centralized direction – transactions costs

Transactions Costs • Outsourcing entail costs of negotiating, writing and enforcing contracts • Costs are incurred due to opportunistic behavior of parties to the contract and efforts to prevent such behavior • Transactions costs explain why economic activities occur outside the price system

Transactions Costs • Sources of transactions costs • Investments that need to be made in relationship specific assets • Possible opportunistic behavior after the investment is made (hold up problem) • Quasi-rents (magnitude of hold up problems)

Relationship-Specific Assets • Relation-specific assets are essential for a given transaction • These assets cannot be redeployed for another transaction costlessly • Once the asset is in place, the other party to the contract cannot be replaced costlessly, because the parties are locked into the relationship to some degree

Relationship-Specific Assets: Examples • An aluminum refiner invests in a refinery designed to process a particular grade of bauxite ore • The French government invests in transportation infrastructure for Euro-Disney

Forms of Asset Specificity • Relation-specific assets may exhibit different forms of specificity • Site specificity • Physical asset specificity • Dedicated assets • Human asset specificity

Rent and Quasi-rent • The term ‘rent” denotes economic profits – profits after all the economic costs, including the cost of capital, are deducted • Quasi-rent is the excess economic profit from a transaction compared with economic profits available form an alternate transaction

Rent and Quasi-rent • Firm A makes an investment to produce a component for Firm B after B as agreed to buy from A at a certain price • At that price A can earn an economic profit of π1 • If A were to renege on the agreement and B is forced to sell its output in the open market, the economic profit will be π2

Rent and Quasi-rent • Rent is the minimum economic profit needed to induce A to enter into this agreement with B (π1) • Quasi-rent is the economic profit in excess on the minimum needed to retain A in the selling relationship with B (π1- π2)

The Holdup Problem • Whenever π1 > π2, Firm B can benefit by holding up A and capturing the quasi-rent for itself • A complete contract will not permit the breach • With incomplete contracts and relationship-specific assets, quasi-rent may exist and lead to the holdup problem

Effect on Transactions Costs • The holdup problem raises the cost of transacting exchanges • Contract negotiations become more difficult • Investments may have to be made to improve the ex-post bargaining position • Potential holdup can cause distrust • There could be underinvestment in relation specific assets

Holdup and Contract Negotiations • When there is potential for holdup, contract negotiations become tedious as each party attempts to build in protections for itself • Temptations on the part of either party to holdup can lead to frequent renegotiations • There could be costly disruptions in the exchange

Holdup and Costly Safeguards • Potential for holdup may lead parties to invest in wasteful protective measures • Manufacturer may acquire standby production facility for an input that is to be obtained from a market firm • Floating power plants are used in place of traditional power plants to avoid site specific investments

Holdup and Distrust • Potential holdups cause distrust between parties and raise the cost of transactions • Distrust can make contracting more costly since contracts will have to be more detailed • Distrust affects the flow of information needed to achieve process efficiencies

Holdup and Underinvestment • When there is a holdup, the investment made in relationship-specific assets loses value • Anticipating holdups, firms will make otherwise sub-optimal level of investments and suffer higher production costs

Asset Specificity and Transactions Costs • Relation-specific assets support a particular transaction • Redeploying to other uses is costly • Quasi rents become available to one party and there is incentive for a holdup • Potential for holdups lead to • Underinvestment in these assets • Investment in safeguards • Reduced trust

Summary • Production activities flow from upstream suppliers to downstream manufacturers, distributors, and retailers (vertical chain). • The “make or buy” problem determines the vertical boundaries of a firm. • The solution to this problem depends on option leads to most efficient production. • This requires an assessment of the cost and benefits of using the market.

Summary • Market firms can exploit economies of scale to produce a component cheaper. • Market firms are subject to competition which encourages efficiency and innovation. • Vertically integrated firms might face agency and influence costs.

Summary • Use of market transactions entails coordination problems (especially for production of inputs with complex design requirements). • Use of market transactions may lead to lose control of valuable private information. • Use of market transaction might entail contracting costs.

ECP 6701 Competitive Strategies in Expanding Markets