Organizing Vertical Boundaries

Introduction There are various approaches in considering the merits of vertical integration balancing transactions costs the role of market imperfections the role of asset ownership There are also alternatives to vertical integration tapered integration joint ventures networks implicit contracts

Technical versus Agency Efficiency The firm economizes in balancing technical and agency efficiency technical efficiency use least-cost production techniques ignoring agency costs from incomplete contracts relates to production agency efficiency minimize coordination, agency and transactions costs relates to exchange

An illustration $ k k measures asset specificity TT  T gives the difference in minimum production cost from internal versus external production  T > 0: internal production costs are never lower than external - economies of scale  A gives the difference in agency costs from internal versus external production AA If the input is purchased from an outside supplier agency costs include negotiation, writing and enforcing contracts If the input is purchased from an outside supplier agency costs include negotiation, writing and enforcing contracts If the input is sourced internally agency costs are the agency and influence costs discussed before If the input is sourced internally agency costs are the agency and influence costs discussed before When the degree of asset specificity is low  A > 0 When the degree of asset specificity is low  A > 0 When the degree of asset specificity is high  A < 0 When the degree of asset specificity is high  A < 0  C is the vertical sum of  T and  A. It is the difference between production and exchange costs with vertical integration and these costs with market exchange CC k* k** When the degree of asset specificity is less than k* market exchange has lower transactions costs When the degree of asset specificity is less than k* market exchange has lower transactions costs When the degree of asset specificity is less than k** market exchange is the preferred mode When the degree of asset specificity is less than k** market exchange is the preferred mode When the degree of asset specificity is greater than k** vertical integration is the preferred mode When the degree of asset specificity is greater than k** vertical integration is the preferred mode Vertical integration is preferable when economies of scale are weak and asset specificity is high

The illustration (cont.) $ k Now consider the impact of market growth on the internal/external choice TT AA CC k* k** k*** An increase in market size causes TT to fall An increase in market size accentuates the advantage of the mode of production with lower exchange costs and so twists AA around k* The overall effect is to change CC and move k** to the left to k*** An increase in market size reduces the critical degree of asset specificity above which vertical integration is preferred

Vertical integration (cont.) Three important conclusions Scale and scope economies gain less from vertical integration when scale and scope economies are strong Product market scale and growth gain more from vertical integration in large and growing markets Asset specificity gain more from vertical integration when production involves investment in relationship-specific assets Consistent with much real-world evidence

Vertical Integration and Asset Ownership Resolution of make-or-buy decision determines ownership if right of use is granted the owner retains residual rights of control When ownership is transferred control rights are lost With complete contracts ownership does not matter contracts specify obligations and rewards With incomplete contracts ownership affects investment in relationship-specific assets form of integration (backward/forward) affects investment in relationship-specific assets

Asset ownership (cont.) Possession of residual control improves bargaining power over operating decisions capture more of the economic value created more likely to invest in relationship-specific assets Implies that vertical integration is desirable and residual control should be exercised by: the unit whose investment in relationship-specific assets has the greatest impact on value creation Further implies that “partial” vertical integration is possible retain ownership of specialized machinery, dies used by outside contractors

Process Issues in Vertical Mergers The desirability of a vertical merger is affected by its impact on technical and agency efficiency It is also affected by governance issues managers of the acquired unit have to cede control post- merger but they must be given decision-making power commensurate with their control over specialized resources e.g. human capital decision-making rights should be given to managers with the greatest influence in performance and profitability  if success depends on synergies associated with physical assets, centralize  if success depends on specialized knowledge of acquired managers, decentralize

Process issues (cont.) The governance structure that emerges may well exhibit path dependence past circumstances determine governance structure  immediate post-merger conflict undermines the potential for future cooperation affects relationship between parent and a spun-off unit  may maintain long-term informal association affects capacity to sell outside the vertically integrated unit  internal division does not usually have this expertise: the external market is a distraction  an acquired supplier does have this expertise: it had marketing capacity prior to acquisition

Alternatives to Vertical Integration There are at least four alternatives tapered integration joint venture/strategic alliance collaborative relationships between buyers and sellers long-term implicit contracts

Tapered integration Mixture of vertical integration and market exchange produce some internally and purchase the remainder  Coca-Cola and Pepsi own some bottlers and contract with others Three benefits expands input and output channels without substantial capital outlay use internal costs and profits to influence external negotiations and external supplier as a yardstick to control internal division protects against the threat of hold-up by external suppliers But sacrifices economies of scale; makes coordination more difficult; makes monitoring more difficult

Strategic Alliances and Joint Ventures Increasingly common arrangements Strategic alliance collaborate on a project share information/productive resources  horizontal between firms in the same industry (Ford and Mazda)  vertical between a supplier and buyer (TI and ACER in chip production)  across industries (Toys “R” Us and McDonald’s in Japan) Joint venture firms create and jointly own a new, independent organization  Coca-Cola and Cadbury-Schweppes arrangement to sell Coke in the UK

Alliances (cont.) Members of the alliance remain independent But there is cooperation, coordination and information sharing Features that make alliances desirable impediments to comprehensive contracting: evolving relationship transaction is complex involves creation of relationship-specific assets by both parties costly for either party to develop the expertise of the other market opportunity is transitory or uncertain market opportunity arises in a regulatory environment with unique features that require a local partner

Alliances (cont.) There are drawbacks risk of leakage of information and loss of control of proprietary information  the alliance usually requires extensive information sharing between independent firms efficient coordination may be difficult to achieve  no formal mechanism for resolving disputes suffers from agency and influence costs  effort split across independent firms  potential free-rider problem: neither party has the incentive to monitor effectively because they not not keep all the benefits

Collaborative Relationships Japanese majors tend to be smaller and less vertically integrated than US counterparts rely on networks of subcontractors  long-term relationships: can persist for decades  extensive information sharing and collaboration  delegation of sophisticated responsibilities e.g. component design subcontractors invest in relationship-specific assets and routines Contrast with US/European approach short-term, narrowly defined mediated by contractual rather than informal arrangements

Keiretsu Formal, institutionalized relationship with complex linkages Trading Companies Trading Companies Manuf’g Companies Manuf’g Companies Other financial institutions Banks Life insurance companies Satellite Companies Loans Equity holdings Trade

Long-Term Implicit Contracts Understandings between parties in a business relationship implicit and so unenforceable in court enables coordination through formal planning and development of relationship-specific assets enforced by the underlying long-term nature of the relationship

An illustration Upstream Supplier Upstream Supplier Downstream Firm Downstream Firm Final Consumers Final Consumers Profit p.a. $1 million Profit p.a. $1 million Profit p.a. $1 million Profit p.a. $1 million Both parties have alternative trading partners with profits of $900,000 p.a. if forced to switch Both parties have alternative trading partners with profits of $900,000 p.a. if forced to switch Both parties can increase profits to $1.2 million by reducing commitment to the relationship Both parties can increase profits to $1.2 million by reducing commitment to the relationship Should commitment be reduced? Should commitment be reduced? Gain: one-off increase of $200,000 Loss: long-term loss of $100,000 from collapse of relationship Present value of loss = $100,000/r Stick with the implicit contract so long as r < 50%