1. AEC 422 See Besanko Ch 3 and Ch 4 ( pp.132-151)
Unit 1
Microeconomics of the Firm
Vertical Integration
AEC 422
See Besanko Ch 3 and Ch 4 ( pp )

2. Vertical Chain Begins with the acquisition of raw materials
Ends with the sale of finished goods/services
Can include support services such as Finance and Marketing
Organizing the vertical chain is an important part of business strategy
Channel management

3. Organization of the Business
Firm Infrastructure
Human Resource Management
Support
activities
Technology Development
Procurement
Profit
Margin
Primary
activities
Inbound
Logistics
Outbound
Logistics
Marketing
& Sales
Service
Operations
Porter’s Organization of the Firm

4. Supply Chain Management
Many small firms choose to outsource to secure use of certain assets made available in the market by other firms
Advertising
Tax management
Distribution
Web management
“upstream” suppliers provide many kinds of resources to operate the firm.
Most firms have many types of suppliers
Scope of activities within a firm can be many
Production, research, packaging, distribution
Key Supplier or Partner
YOUR FIRM
Key Customer

5. Supply Chain Management
Many small firms choose to outsource to secure use of certain assets made available in the market by other firms
Advertising
Tax management
Distribution
Web management
“upstream” suppliers provide many kinds of resources to operate the firm.
Scope of activities within a firm can be many
Production, research, packaging, distribution
Key Supplier or Partner
YOUR FIRM
Key Customer

6. Outsourcing and integrating
UPS Supply Chain Solutions
Accountemps - Accounting Staffing Agency
Vineyard – winery
Web design
Q-Labs microbial testing
Papa Johns
Foodservice, Inc.
Upstream
Firm
Downstream

7. 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)
Like criteria for scope economies – which system is cheaper?
Some creative uses of outsourcing – implications for the balance sheet

8. Make or Buy Continuum Arm’s length Market Transactions Less Integrated
Long-Term Contracts
Strategic Alliances/Joint Ventures Vertical Coord.
Parent/Subsidiary Relationship
More Integrated
Perform Activity Internally

9. Do we make it ourselves or buy it?
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)

10. Do we make it ourselves or buy it?
Other factors
Frequency and volume of purchase/need
Uniqueness of the asset
Proprietary nature of the product
Also relates to the merger & acquisition issue
Sometimes the best strategy is to pursue vertical integration

11. Grape Sourcing by MidSouth Wineries
% Grown in own vineyards
% contracted with other growers
% purchased on spot market
Small Wineries (<3000 cases)
64.1
29.0
6.2
Larger Wineries (3000 or more cases)
45.4
41.5
11.9
Source: 2011 Winery Price and Market Survey

12. Elk Creek Winery, KY

13. Benefits and Costs of Using the Market
BENEFITS: - can be cheaper
Market Firms Can Achieve Economies of Scale:
In-House Production May Be Too Low
Market Firms Must Be Efficient to Survive In The Market Environment
COSTS: - may be hidden costs
Coordination May Be Compromised
Private Information May Be Leaked
There May Be High Transaction Costs In The Market
ie, search, paperwork, post-purchase recourse

14. Benefits of Using the Market
Market firms (outside specialists) may have patents/proprietary information that makes low cost production possible
Market firms can sometimes achieve economies 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)
Often there are choices in channel partners with which to work

15. Agency Costs
Does the outside firm have the same commitment to the delivery of the product or service needed?
Not always - conflicts of interest, other clients
Example: Purity Foods, Inc.
Can have internal agency costs, too – managers & workers knowingly do not act in the best interest of the business

16. Influence costs
In addition to internal agency costs, performing a task in-house will lead to “influence costs” as well
Influence cost – time consumed by a manager campaigning central management to allocate resources to his/her division
Note – a poor process of external “bidding” can add to the cost of outsourcing, as well. Need to find the right firm the first time.

17. Problems in Using the Market: Lack of Control
Costs imposed by poor coordination
Reluctance of partners to 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

18. Candy New Product Development
Upstream
Firm
Downstream
…..outsourcing generally adds to development time.
Source: Woods and Spaulding, J Food Distr Research 2006

19. Make or Buy Continuum Arm’s length Market Transactions Less Integrated
Long-Term Contracts
Strategic Alliances/Joint Ventures Vertical Coord.
Parent/Subsidiary Relationship
More Integrated
Perform Activity Internally

20. Complete Contract
A complete contract stipulates what each party should do for every possible contingency
No party can exploit others’ weaknesses
To create a complete 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

21. 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

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

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

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

25. 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

26. 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

27. 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
Timing
Size
Color
Sequence
R & D
Case in point: Private Label
Grocery Products

28. Private Label Share by Department
Source: IRI 2012, Multi-outlet supermarkets, drug stores, mass market retailers

29. 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

30. Design Attributes
Design attributes are attributes that need to relate to each other precisely; else significant loss in economic value results
Some examples
Sequencing of courses in AEC degree
Fit of auto sunroof glass to aperture
Timely delivery of a critical component

31. Design Attributes
If coordination is critical, administration control may replace the market mechanism
Design attributes may be moved in-house
Pepsi-Cola and its Bottlers

32. Make or Buy Continuum Arm’s length Market Transactions Less Integrated
Long-Term Contracts
Strategic Alliances/Joint Ventures Vertical Coord.
Parent/Subsidiary Relationship
More Integrated
Perform Activity Internally

33. Alternatives to Vertical Integration
Tapered integration (making some and buying the rest)
Joint ventures and strategic alliances
Long term collaborative relationships
Implicit contracts between firms

34. Tapered Integration in Gasoline Retailing
Major oil refiners sell through their own service stations and through independently owned stations
As gas stations have moved away from auto repair and maintenance services, the proportion of company owned stations are growing

35. Alliance Relationships
Transaction based
Alliance based
Short-term relationships
Multiple suppliers
Adversarial relationships
Price dominates
Minimal investment from suppliers
Minimal information sharing
Firms are independent
Minimal interaction between respective functional areas
Long-term relationships
Fewer suppliers
Cooperative partnerships
Value-added services dominate
High investment for both buyer and supplier
Extensive product, marketing, and logistics information sharing
Firms are interdependent with joint decision making
Extensive interaction between buyer and supplier functional areas
Source: D. Ross: Competing Through Supply Chain Management, 1999

36. Supply Chain Management
Integration (make or buy) ultimately about the structure that delivers the greatest value
Internal vs external economies
Key Supplier or Partner
YOUR FIRM
Key Customer