Vertical Boundaries Of The Firm
Abhijit Sharma
Economics of Industry: Lecture 3
MAN0201M

Lecture overview
In this lecture, we will consider: •! Vertical integration and the vertical chain" •! Make versus buy decision" •! Role of contracts" •! Agency costs and influence costs" •! Transactions costs" •! Asset specificity " •! Summarise key points" [Refer to Besanko, Ch 3.]"

Vertical chain
•! •! •! •! Begins - acquisition of raw materials Ends - sale of finished goods/services Includes support services (finance and marketing) Organising 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 outsourced? •! Choice between the “invisible hand” of the market and the “visible hand” of the organisation (make or buy decision).

Vertically integrated firms
•! In vertically integrated firms, many steps in the vertical chain are performed in-house. Example: De Beers. •! Some firms choose to outsource tasks within the chain tasks and become vertically disintegrated. Example: Nike or Adidas. Make versus buy •! Decision depends on 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).

Stages in the product transformation process in the car industry

Corporate integration

Defining boundaries
•! Firms need to define their vertical boundaries. •! Factors to be considered –! 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. These include decisions such as (a) whether independent firms should merge and (b) whether a firm can achieve long-term cost advantages in the market through expansion. "

Mergers in the EU

Number of M&As notified to the European Commission, 1990–2003 Source: CEC, 2003

Some make or buy fallacies
•! Firm should make rather than buy assets that provide competitive advantages. •! Outsourcing an activity eliminates the cost of that activity. •! Backward integration captures the profit margin of the supplier. •! Backward integration insures against the risk of high input prices. •! It makes sense to tie up the distribution channel in order to deny access to the rivals.

Outsourcing and cost
•! It should not matter if the costs of performing an activity are incurred by the firm (make) or by the supplier (buy). •! The relevant consideration is whether it is more efficient to make or to buy. Backward integration and profits •! The supplier’s profit margin may not represent any economic profit, and profit margin should “pay” for the capital investment and the risk borne. •! If the supplier is earning economic profit, what is the reason for its persistence? •! Market competition should eventually erode away the economic profit.

Reasons to buy rather than make
•! Market firms (third party specialists) may have patents/ proprietary information that makes low cost production possible. •! Such firms may be able to achieve economies of scale that in-house units cannot. •! External 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).

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 a firm. •! It is difficult to internally replicate the incentives faced by market firms. E.g. innovation in USSR." Influence costs" •! In addition to agency costs, performing a task inhouse will lead to “influence costs” as well. •! “Internal capital