Boeing 787 production network Flaps (Boeing Australia) Final Assembly Boeing Everett,WA Tail fins (Boeing, Frederickson, WA) Fuselage (Spirit AS, Kansas) Horiz. Stabil. (Alenia, Italy) Wings (MHI, Japan) Landing gear (Messier, France) Titanium forgings (Russia)

Chapter 8: Internalization Keith Head Sauder School of Business

The “take-away” for chapter 8 Firms must decide what things they will do themselves, and what they will “outsource” to/from other firms Business can be carried out through –Short-term (arm’s length, “spot”) transactions –Long-term contractual arrangements –Internalization through ownership Each option has its own problems so there is no “one-size-fits all” solution.

Internalization decision tree Control Long-term Contracts Equity Ownership Spot Transactions Markets Invisible Hand Visible Hand Foreign Direct Investment Licensing, Franchising, Sub-contracting=“outsourcing” (in)Corporation Network

The Case for Markets Range of choice (variety of options) Speed of choice (no up-front costs) Flexibility of choice (option to change) Adam Smith’s (1776) invisible hand: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest”

Where spot markets can fail Relationship-specific investment (RSI), –ex post bilateral monopoly –The hold-up problem. Vertical incentive conflict (CC in France) –Over-pricing –Under-promotion Information-transfer transactions Reputation-transfer transactions

Contractual solutions Long-term, contractually-specified prices Two-part tariffs (e.g. $175K franchise fee to operate a McDonalds restaurant) Intellectual property law (patents & trademarks) Non-compete clauses Franchising agreements (McDonald’s 400- page operating manual)

When contracts fail Lack of enforcement –Punishing firms that breach contracts Problems in “Verifiability” –Courts must decide if breach has occurred Unforeseen contingencies –Contracts must cover all the important things that might happen

Examples of Contract-based International Business Labatt & Anheuser-Busch IKEA Benetton Boeing & Rolls-Royce Nike and its “sub-contractors” Coca-Cola and its’ bottler-distributors McDonalds and its restaurant franchises OEMs/EMS (e.g. Flextronics) and VARs

Why not just internalize? Financing costs of ownership Risks of ownership Inflexibility Firm-level comparative advantage –“Spanning” costs (diluted attention) –“Incompetence” costs