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Vertical Integration and The Scope of the Firm Transactions Costs and the Scope of the Firm --Why does the firm exist? --The evolution of firms and markets.

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Presentation on theme: "Vertical Integration and The Scope of the Firm Transactions Costs and the Scope of the Firm --Why does the firm exist? --The evolution of firms and markets."— Presentation transcript:

1 Vertical Integration and The Scope of the Firm Transactions Costs and the Scope of the Firm --Why does the firm exist? --The evolution of firms and markets The Costs and Benefits of Vertical Integration Designing Vertical Relationships Recent Trends OUTLINE

2 From Business Strategy to Corporate Strategy: The Scope of the Firm Business Strategy is concerned with how a firm computes within a particular market Corporate Strategy is concerned with where a firm competes, i.e. the scope of its activities The dimensions of scope are –geographical scope –vertical scope –product scope

3 P1P1 P2P2 P3P3 C1C1 C2C2 C3C3 VerticalProduct Geographical ScopeScopeScope V1V2V3V1V2V3 P3P3 P2P2 P1P1 C3C3 C2C2 C1C1 V1V1 V2V2 V3V3 [A] Single Integrated Firm [B] Several Specialized Firms linked by Markets In situation [A] the business units are integrated within a single firm. In situation [B] the business units are independent firms linked by markets. Are the administrative costs of the integrated firm less than the transaction costs of markets? Transactions Costs and the Scope of the Firm

4 Transactions Costs and The Existence of the Firm Transaction cost theory explains not just the boundaries of firms, also the existence of firms. In 18th century English woollen industry, no firms – independent spinners and weavers linked by merchants. Residential remodeling industry -- mainly independent self- employed builders, plumbers, electricians, painters. Key issue -- transaction costs of the market vs. administrative costs of firms. Where transaction costs high—firm is more efficient means of organization Note: transaction costs = cost of locating, negotiating, and enforcing a contract.

5 Changes in Aggregate Concentration Over Time For most of the 19 th & 20 th centuries industrial firms have expanded their vertical, geographical and product scope. Why? From the late 1970s to the mid-1990s, this trend reversed. Large companies began downsizing, outsourcing, and refocusing. Why? Why the recent renewal of concentration in the industrial sector? 1930 1940 1950 1960 1970 1980 1990 1997 50% 20% 35% Sales of 100 biggest cos. as % of US industrial output

6 Determinants of Changes in Corporate Scope 1800 – 1980 Expanding scale and scope of industrial corporations due to declining administrative costs of firms: Advances in transportation, information and communication technologies Advances in management—accounting systems, decision sciences, financial techniques, organizational innovations, scientific management 1980 – 1995 Shrinking size and scope of biggest industrial corporations. Increasingly Increased no. of managerial Admin. costs of turbulent decisions. Need for fastfirms rise relative external responses to external to transaction environment changecosts of markets 1995 – 2004 Rapid increase in global concentration (autos, aluminium, oil, beer, banking, cement). Key drivers: quest for market power and scale economies. Also, large corporations becoming more entrepreneurial and agile

7 The Costs and Benefits of Vertical Integration: BENEFITS Technical economies from integrating processes e.g. iron and steel production —but doesn’t necessarily require common ownership Superior coordination Avoids transactions costs of market contracts in situations where there are: -- small numbers of firms -- transaction-specific investments -- opportunism and strategic misrepresentation -- taxes and regulations on market transactions

8 The Costs and Benefits of Vertical Integration: COSTS Differences in optimal scale of operation between different stages prevents balanced VI Strategic differences between different vertical stages creates management difficulties Inhibits development of and exploitation of core competencies Limits flexibility -- in responding to demand cycles -- in responding to changes in technology, customer preferences, etc. (But, VI may be conducive to system-wide flexibility) Compounding of risk

9 When is Vertical Integration More Attractive than Outsourcing? How many firms are availableThe fewer the companies to undertake the activities?the more attractive is VI Is transaction-specific investmentIf yes, VI more attractive needed? Does limited information permitVI can limit opportunism cheating? Are taxes or regulation imposed VI can avoid them on transactions? Do the different stages have similar Greater the similarity, the optimal scales of operation?more attractive is VI Are the two stages strategically Greater the strategic similar?similarity ---the more attractive is VI How great the need for entrepreneurshipGreater the need, the greater & continual upgrading of capabilitiesthe disadvantages of VI How uncertain is market demand?Greater the unpredictability ----the more costly is VI Are risks compounded byVI increases risk. linkages between vertical stages

10 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?

11 Recent Trends in Vertical Relationships From competitive contracting to supplier partnerships, e.g. in autos 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.

12 Different Types of Vertical Relationship Spot sales/ purchases Long-term contracts Agency agreements Franchises Vertical integration Joint ventures Informal supplier/ customer relationships Supplier/ customer partnerships Low Degree of Commitment High Low Low Formalization High


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