Strategic Analysis: Vertical Integration Part I Notes

Strategic Analysis: Vertical Integration Part I

Additional Chapters

  • Part of this topic is included in Besanko Chapter 5 and 6.
  • The PDF is available on the e-learning platform.
  • Download the PDF by April 11th.

The Topic in Practice

  • Luxury brands are acquiring suppliers.
  • This brings benefits to both sides but may also lead to difficulties and high costs.

Strategic Planning Process

  • Mission, Vision, Values.
  • External Analysis.
  • Internal Analysis.
  • SWOT Analysis.
  • Corporate Strategy (Where?).
  • Business Strategy (How?).
  • Value Creation.

Recap

  • Resource-Based View.
  • Diversification strategy:
    • Different modes of diversification.
    • Related and unrelated diversification.
    • Portfolio matrices to measure a diversified portfolio.
  • Vertical integration strategy.
  • Horizontal integration.

Vertical Integration: Definition

Definition Part I

  • VERTICAL CHAIN: The process that begins with the acquisition of raw materials and ends with the distribution and sale of finished goods and services.
  • Key issue in strategy is how to organize the vertical chain.
  • CORE QUESTION: Is it better to organize all of the activities in a single firm, or to rely on independent firms in the market?

Definition Part II

  • VERTICAL BOUNDARIES: The activities performed by the firm itself as opposed to purchases from independent firms in the market.

Make VS Buy

  • A firm’s decision to perform an activity itself or to purchase it from an independent firm is called a make-or-buy decision.
    • MAKE: the firm performs the activity itself.
    • BUY: the firm relies on independent firms to perform the activity, perhaps under contract.
  • A firm that acquires an input supplier is now «making» the input, because it is performing the activity in-house.

Make VS Buy Considerations

  • Firms may succeed by either performing their own activities or buying from market specialists.
  • Specialists may offer advantages such as rapid and low-cost distribution or marketing programs.
  • It is not always desirable to BUY.
  • A critical task is to define firm boundaries: which tasks to make and which to buy?

Defining Boundaries

  • To define its boundaries, a firm must compare the benefits and costs of using the market (BUY) as opposed to performing the activity in-house.

Decisions Associated with Vertical Integration

  • Establish the boundaries of the firm’s activity.
  • Establish the relationship to external counterparts.
  • Identify opportunities & threats that may be changing current boundaries for the firm.

Reasons to Buy

  • Firms usually «buy» because market firms are often more efficient.
    1. Economies of scale and learning curve.
    2. Low bureaucratic constraints.

Reasons to Buy (Continued)

  • Market firms may own proprietary information or patents that enable them to produce at lower cost.
  • Market firms may be able to aggregate the needs of many firms and thus enjoy economies of scale.
  • Market firms may be able to exploit their experience in producing for many firms to obtain learning economies.

Enjoying Economies of Scale and Learning I

  • By aggregating demands of many potential buyers, market firms can often achieve greater scale, and thus lower unit costs, than can the downstream firms that use the input.
  • Vertically integrated firms typically produce only for their own needs.

Enjoying Economies of Scale and Learning II

  • Example: An automobile manufacturer requires many different upstream inputs (steel, tires, brakes) and can:
    • i) backward integrate and produce inputs itself, or
    • ii) it could buy them from external suppliers.
  • Figure 5.3 illustrates an average cost function for brakes: their production shows a L shaped average costs, indicating that there are economies of scale in production.
  • The minimum efficient scale of production – the smallest level of output at which average cost is minimized – is output A, with costs C.

Production Costs and the Make-or-Buy Decision

  • Firms need to produce quantity A* to reach minimum efficient scale and achieve average costs of C*.
  • A firm that requires only A' units to meet its own needs will incur average costs of C', well above C*.
  • A firm that requires output in excess of A, such as A", will have costs equal to C and will not be at a competitive disadvantage.

Enjoying Economies of Scale and Learning III

  • Suppose that an automobile manufacturer (Chrysler) expects to sell A’’ automobiles with brakes, where A’’>A∗A’’> A*.
  • Thus, it expects to sell enough autos to achieve minimum efficient scale in the production of brakes by producing for its own needs alone (average cost of output A’’ roughly equals C*).
  • The manufacturer gets no advantage by using the market.

Enjoying Economies of Scale and Learning IV

  • Suppose that Chrysler expects to sell A’ automobiles with brakes, where A’<A∗A’< A*.
  • Thus it cannot achieve minimum efficient scale by producing only for its own needs (in Figure 5.3, the average cost associated with output A’ denoted C’ > minimum average cost C*)
  • Chrysler could try to expand antilock brake output to A*, thereby achieving scale economies. However, it would be producing more brakes than cars: it would have to convince other car makers to buy some of its brakes. This seems unlikely.

Enjoying Economies of Scale and Learning V

  • Alternatively, Chrysler could purchase antilock brakes from an independent manufacturer TRW.
  • TRW would reach production of A’ in Figure 5.3 just from its sales to Chrysler.
  • Because there are many more car manufacturers than there are brake makers, TRW will probably sell brakes to other manufacturers – so expanding its output beyond A’ and achieving scale economies.

Reasons to Buy (Revisited)

  • Firms usually «buy» because market firms are often more efficient.
    1. Economies of scale and learning curve.
    2. Low bureaucratic constraints.

Bureaucracy Effects: Agency Costs

  • Managers and workers who knowingly do not act in the best interests of their firm are slacking.
  • Agency costs are the costs associated with slack effort and with administrative controls to deter it.
  • Agency costs reduce the firm’s profitability because workers take steps in their own best interests, which are not necessarily in the best interests of the firm.

Bureaucracy Effects: Agency Costs (Continued)

  • In vertically integrated firms, agency costs and the associated loss of profits may go unnoticed.
  • Reasons:
    1. Most large firms have common overhead or joint costs that are allocated across divisions, making it difficult to measure and reward individual division contributions.
    2. In-house divisions often serve as cost-centers that perform activities solely for their own firms and generate no outside revenue.
    3. Management may prefer to ignore agency costs rather than eliminate them, being unwilling to endure the ill will generated by firing a non-productive worker.

Bureaucracy Effects: Influence Costs

  • If internal capital is scarce, then when resources are allocated to one division or department, fewer resources are available to be allocated to others.
  • Managers will attempt to influence this allocation.
  • Influence costs include the direct costs of influence activities and the costs of bad decisions arising from influence activities.
  • A large, vertically integrated firm may be prone to influence costs that a smaller, independent firm may avoid.

Reasons to Make

  • Costs of poor coordination between steps in the vertical chain.
  • Reluctance of trading partners to develop and share valuable information.
  • Transaction costs.
  • Each of these problems can be traced to costs associated with writing and enforcing contracts.

The Economic Foundations of Contracts

  • Contracts define the conditions of exchange
  • Standardized vs. Tailored

Why Firms Use Contracts

  • List the set of tasks that each contracting party expects the other to perform.
  • Specify remedies in the event that one party does not fulfill its obligations (protect parties from opportunities behavior).

The Effectiveness of Contracts Depends On

  1. The «completeness» of the contract.
  2. The available body of contract law.

The Completeness of the Contract

  • A complete contract eliminates opportunistic behavior, as it binds the parties to particular courses of action as the transaction unfolds.
  • Three factors prevent complete contracting:
    1. Bounded rationality.
    2. Difficulties specifying or measuring performance.
    3. Asymmetric information.

I) Bounded Rationality

  • Refers to limits on the capacity of individuals to process information, deal with complexity and pursue rational aims.
  • Parties cannot contemplate or foresee every contingency that may arise during a transaction.
  • This means they cannot write complete contracts.

II) Difficulty Specifying or Measuring Performance

  • The more the performance under a contract is complex or subtle, the more difficult it would be to disentangle each party’s rights and responsibilities.
  • Performance may be ambiguous or hard to measure.

III) Asymmetric Information

  • Even if the parties were not boundedly rational and could measure performance, a contract may still be incomplete because the parties do not have equal access to all contract-relevant information.
  • If one party knows something that the other does not, then information is asymmetric, and the knowledgeable party may distort or misrepresent that information.

The Available Body of Contract Law

  • A well-developed body of contract law makes it possible for transactions to occur smoothly when contracts are incomplete.
  • However, contract law is not a perfect substitute for complete contracting for two important reasons:
    1. Doctrines of contract law are phrased in broad language that is open to differing interpretations when applied to specific transactions.
    2. Litigation can be a costly way of completing contracts.

Reasons to Make (Revisited)

  • Costs of poor coordination between steps in the vertical chain.
  • Reluctance of trading partners to develop and share valuable information.
  • Transaction costs.

Coordination of Production Flows Through the Vertical Chain

  • Contracts between independent firms are often essential for ensuring the coordination of production.
  • For coordination to succeed, players must make decisions that depend, in part, on the decisions of others.
  • Working together, firms can ensure a good fit along all dimensions of production.
  • Without good coordination, bottlenecks may arise.

Transaction Costs

  • TRANSACTION COSTS: Costs of using the market that can be eliminated by using the firm.
  • Three important theoretical concepts from transactions-costs economics:
    • Relationship specific assets
    • Rents and Quasi rents
    • Holdup problem

Relationship Specific Assets

  • Investment made to support a given transaction.
  • The asset is often essential for the efficiency of a particular transaction.
  • Asset specificity can take at least four forms:
    1. Site specificity: assets that are located side-by-side to economize on transportation or other costs.
    2. Physical asset specificity: assets whose physical or engineering properties are specifically tailored to a particular transaction.
    3. Dedicated assets: investment in plant and equipment made to satisfy a particular buyer.
    4. Human asset specificity: workers that have acquired skills and know-how that are more valuable inside a particular relationship than outside it.