Economics of Strategy The Vertical Boundaries of the Firm

Vertical Boundaries of the Firm The Vertical Chain “Upstream” “Downstream” The Value Chain

The Vertical Chain all activities which are associated with the flow of production from inputs to output

The Value Chain (Porter) inbound logistics manufacturing operations outbound logistics marketing and sales customer service

The Make-or-Buy Decision Three Common Fallacies –“Firms should generally buy, rather than make, to avoid paying the costs necessary to make the product” –“Firms should generally make, rather than buy, to avoid paying a profit margin to other independent firms” –“Firms should make, rather than buy because a vertically integrated producer will be able to avoid paying high market prices for the input during periods of scare supply or peak demand”

“Firms should generally buy, rather than make, to avoid paying the costs necessary to make the product” All firms, regardless of their corporate structure, have to cover the production costs of the goods and/or services which they provide

“Firms should generally make, rather than buy, to avoid paying a profit margin to other independent firms” All firms, regardless of their corporate structure, have to cover their opportunity costs. This includes a market rate of return on your investment. Accounting Costs Vs. Economic Costs

“Firms should make, rather than buy because a vertically-integrated producer will be able to avoid paying high market prices for the input during periods of scare supply or peak demand” Internal transfer prices should equal the external market price. –External market prices are your best available indicators of opportunity costs –Downstream product prices reflect changes in upstream prices

Benefits of Using the Market Reasons to “Buy” Economies of Scale Market Firms are subjected to the rigors of the market

Economies of Scale lower per unit costs associated with large scale production lower per unit costs arise with specialization “the division of labor is limited by the extent of the market”

Market Firms are subjected to the rigors of the market Agency Costs within the firm Influence Costs within the firm Exposing Internal Divisions to Competition/Market Forces

Agency Costs occur when a principle delegates decision-making authority to another party, the agent Why? –the principal recognizes that he/she is relatively uninformed about the proper course of action and this problem is best resolved by relying upon the external expertise of the agent Asymmetric Information –home seller/buyer and real estate agents –attorney and client –physician and patient –auto mechanic and auto owner

Agency Costs will likely reduce firm value when the agent represents their personal interests agency costs disappear when owners are the agent

Influence Costs internal politics “rent-seeking” - lobbying the structure for benefits for oneself or one’s unit Influence costs disappear when owners are managers

Influence Costs increase firm costs – time spent politicking is time not spent on task politics can cause decision-making to be based on inappropriate criteria –our fundamental criterion is increasing firm value can lead to destructive internal competition uses scarce resources, time, energy

Exposing Internal Divisions to External Market Forces market discipline is ongoing and consistent provides an opportunity to compare the capabilities of internal sources with what is available in the market. Hence, assists in the “make-or-buy” decision

Costs of Using the Market Reasons to “make” coordination costs within the vertical chain –time, size, quality, color, fit, critical specifications, sequence leakage of private information transactions costs –the costs of negotiating, monitoring, and consummating a contractual arrangement