1. Economics of Strategy Chapter 4 Organizing Vertical Boundaries:
Besanko, Dranove, Shanley and Schaefer, 3rd Edition
Chapter 4
Organizing Vertical Boundaries:
Vertical Integration and its Alternatives
Slide show prepared by
Richard PonArul
California State University, Chico
 John Wiley  Sons, Inc.

2. Vertical Boundaries
For each step in the vertical chain the firm has to decide between market exchange and vertical integration
The degree of vertical integration differs
Across industries
Across firms within an industry
Across transactions with in firm

3. The Tradeoff in Vertical Integration
Using the market improves technical efficiency (least cost production)
Vertical integration improves agency efficiency (coordination, transactions costs)
Firm should “economize” - choose the best possible combination of technical and agency efficiencies

4. Technical Efficiency Efficiency trade-off model
Using the market leads to higher technical efficiency compared to vertical integration (power of market discipline)
The difference in technical efficiency of market over vertical integration (T) depends on the nature of the assets involved in production

5. Technical Efficiency For a given firm size
As the assets become more specialized the market firm’s economies of scale become weaker
The difference in technical efficiency of market over vertical integration (T) declines with greater asset specificity (k)
 measures loss/gain of efficiency going from market to vertical integration

6. Agency Efficiency
At high levels of asset specificity, differential agency efficiency of market over vertical integration (A) is negative
When specialized assets are involved, potential for a holdup is high and the result is higher transactions costs

7. Agency Efficiency
At low levels of asset specificity, differential agency efficiency of market over vertical integration (A) is likely to be positive
Without the holdup problem, market exchange could be more agency efficient in-house production

8. Technical and Agency Efficiency+
no vertical integration -
vertical integration

9. Efficiency Tradeoff
The combined (market over vertical integration) differential efficiency (C) will be negatively related to asset specificity
At high levels of assets specificity vertical integration is more efficient
At low levels of assets specificity outsourcing wins

10. Efficiency Tradeoff and Scale
When the scale of production increases, the vertically integrated firm enjoys better economies of scale
With increased scale, the differential technical efficiency decreases for every level of asset specificity

11. Efficiency Tradeoff and Scale
With an increase in scale, the differential agency efficiency becomes more sensitive to asset specificity
Differential agency efficiency (market over vertical integration) will increase with scale for low asset specificity
With high asset specificity, differential agency efficiency decreases with scale

12. Efficiency Tradeoff and Scale
Scale increases
(quadrante +)
no vertical integration
Dashed lines:
original position
(quadrante -)
vertical integration

13. Efficiency Tradeoff and Scale
The combined differential efficiency (C) sharply declines for low asset specificity
The degree of asset specificity at which market is just competitive with vertical integration declines
Vertical integration is preferred to market exchange over a larger range of asset specificity

14. Predictions: the Efficiency Tradeoff Model
Inputs in the firm of routine products and services are likely to be procured in the market (supplier’s economies of scale)
When a firm’s product market activities is large in scale, it is likely to be vertically integrated
Presence of relationship-specific assets will tilt the advantage in favor of vertical integration

15. Real-World Evidence
GM is more vertically integrated than Ford is, for the same asset specificity (scale)
In aerospace, greater design specificity increases the likelihood of vertical integration of production
Among utilities, mine-mouth plants are more likely to be vertically integrated compared with other plants

16. The Virtual Corporation
Advances in technology have reduced coordination costs and reduced asset specificity
Consequently, the advantage of market over vertical integration has steadily increased
Virtual corporation is the limit when each element in the vertical chain will be independent

17. Vertical Integration and Asset Ownership
Make-or-buy decision is essentially a decision regarding ownership rights
If contracts were complete, it will not matter who owned the assets in the vertical chain
With incomplete contracts, ownership pattern determines the willingness of each party to make relationship-specific investments

18. Vertical Integration and Asset Ownership
Three ways to organize a transaction in the vertical chain
The two units are independent (non integration)
Upstream unit owns the assets of the downstream unit (forward integration)
Downstream unit owns the assets of the upstream unit (backward integration)

19. Asset Ownership and Integration
The form of integration affects the incentives to invest in relationship-specific assets
Whether vertical integration is optimal or not depends on the relative contribution to value added by each party’s investment

20. Asset Ownership and Integration
If the investments by the upstream player and the downstream player are of comparable importance, market exchange is preferred
If the investment by one player is more important in value creation, vertical integration is preferred

21. Asset Ownership and Integration
Asset ownership is an important dimension of vertical integration
There could be degrees of integration depending on the extent of control over specialized assets
Example: Auto manufacturers can use independent suppliers for body parts but own the dies and stamping machines

22. Human Assets and Vertical Integration
When physical assets are involved, upstream (or downstream) asset ownership can be used along with market exchange
When human assets are important, acquiring control of these assets can be done only through a full fledged vertical integration

23. Process Issues in Vertical Mergers
A merger may be desirable in principle (for vertical integration) but the process may not allow for efficient governance structures after the merger
Efficiency considerations may indicate that the managers of the acquired firm should continue to have certain decision rights; past circumstances may preclude this

24. More Process Issues
After the supplier is acquired, the firm may have difficulty selling to others besides itself (despite the marketing know how)
A spin-off firm may continue to make decisions as if it is part of the parent

25. 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

26. Tapered (ridotta) Integration
Balancing vertical integration and strategic outsourcing
A firm may produce part of its input on its own and purchase the rest
A firm may sell part of its output through in-house sales efforts and sell the rest through independent distributors

27. Tapered Integration: Advantages
Additional input/output channels without massive capital investments
Information about costs and profitability from internal operations can help in negotiating with market firms
Threat of self manufacture can discipline external channels

28. Tapered Integration: Advantages
Internal supply capabilities will protect against potential holdups
Potential expansion of external supply can impose discipline on in-house production

29. Tapered Integration: Disadvantages
Possible loss of economies of scale
Coordination may become more difficult since the two production units must agree on product specifications and delivery times
Managers may be self-serving in continuing with internal production well after it has become inefficient to do so

30. 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

31. Strategic Alliances and Joint Ventures
Alliances involve cooperation, coordination and information sharing for a joint project while the participating firms continue to be independent
A joint venture is an alliance where a new independent organization is created and jointly owned by the promoting firms

32. Strategic Alliance
Alliances and joint ventures are intermediate solutions, between market exchange and vertical integration
Rather than rely on contracts, an alliance relies on trust and reciprocity
Disputes are rarely litigated but resolves through negotiation

33. Strategic Alliance - Scenarios
Uncertainty surrounding future activities prevents the parties from going into the specifics of those decisions in a contract
Transactions are complex and one cannot count on contract law to “fill the gaps”
Existence of relationship-specific assets and potential holdup problem

34. Strategic Alliance - Scenarios
Any one party does not have the expertise to organize the transaction internally
Market opportunity that induced the transaction is expected to last very long making a long term contract or merger unattractive
Regulatory environment necessitates acquiring a local partner for the venture

35. Collaborative Relationships
Japanese industrial firms appear to be less vertically integrated compared to their western counterparts
Japanese firms organize the vertical chain using long term collaborative relationship among firms rather than arm’s length transactions

36. Collaborative Relationships
Two major types of collaborative relationships are found in Japan
Subcontractor networks
Keiretsu

37. Subcontractor Networks
Japanese manufacturers maintain close, informal, long term relationship with their network of subcontractors
The typical relationship between a manufacturer and a subcontractor involves far more asset specificity in Japan than in the West

38. Keiretsu Member firms of a keiretsu hold each other’s equity
Links among firms are further strengthened by personal relationships among top executives
Most of the key activities in the vertical chain are performed by members of the keiretsu with easy coordination and no chance for holdups

39. Implicit Contracts
Implicit contracts are unstated understanding between firms in a business relationship
Longstanding relationship between firms can make them behave cooperatively towards each other without any formal contracts

40. Implicit Contracts
The threat of losing future business (and the future stream of profits) is enough to deter opportunistic behavior in any one period
The desire to protect one’s reputation in the market place can be another mechanism that makes implicit contracts viable