Economics of Strategy The Economics of Vertical Integration

Technical Vs Agency Efficiency There are two major efficiency concerns in any “make-or-buy” decision –Technical Efficiency –Agency Efficiency Tradeoffs exist between technical (production) efficiency and agency (exchange) efficiency as we move from buy to make or vice versa

Technical Efficiency Cost efficiency in the physical production of the good or service –dominated by economies of scale and scope –the firm is minimizing the costs of attaining the input i.e., it is adopting the least-cost method of production, be it internal (make) or external (buy)

Agency Efficiency Striving for efficiency or least cost in the market transactions required to obtain the input –Transactions Costs –Influence Costs –Agency Costs

The Tradeoff Technical EfficiencyAgency Efficiency

The Make-or-Buy Decision Do we “make” or “produce in-house” or “vertically integrate”? Do we “buy” or “obtain from the market” or “outsource” ?

The Asset Specificity Model the choice to vertically integrate or to outsource depends upon –Technical Efficiency –Agency Efficiency –Asset Specificity

Figure 4.1 High asset specificity Vertical Axis: Costs of Vertical Integration - Costs of Outsourcing Costs of vertical integration > Costs of outsourcing Costs to “make” exceed the costs to “buy” IT IS MORE COST EFFFECTIVE TO BUY IT IS MORE COST EFFFECTIVE TO MAKE Costs of vertical integration < Costs of outsourcing Cost to “buy” exceed the costs to “make” Low asset specificity

Figure 4.1 Asset Specificity Costs of vertical integration - Costs of outsourcing   differences in technical efficiency costs when producing the input in-house minus the technical efficiency costs when acquiring the product from a market specialist

 This difference is always in the buy region –market providers are able to achieve more economies of scale and scope by virtue of the fact that they can aggregate demand from numerous sources –This difference is declining because as asset specificity increases it “narrows the market” thereby reducing the available economies of scale and scope

Figure 4.1 Asset Specificity Costs of vertical integration - Costs of outsourcing  agency costs when producing the input in- house minus the agency costs when acquiring the product from a market specialist 

Agency Costs with In-house Production lost efficiency due to agency costs the costs associated with slack effort by employees and the costs of the administrative controls put in place to thwart this. lost efficiency due to internal influence costs Uses time, resources, and energy –time spent politicking is time not spent on task –can lead to destructive internal competition Politics can affect decision-making criteria Transfer prices may be politically determined

Agency Costs with Market Supplier direct costs of contracting costs of safeguarding against hold-up inefficiencies due to underinvestments in relationship specific assets lost opportunities due to mistrust, inability to share sensitive data costs associated with breakdowns in coordination and synchronization

 This difference is positive at low levels of asset specificity –hold-up is not a significant problem –the market for the product is likely to be competitive because the input is “homogeneous” with numerous sellers and buyers –Therefore... Competitive pressure force production costs down Competitive pressures to innovate

 This difference is negative at high levels of asset specificity –requires more detailed contracts (i.e., higher transactions costs) –increases the likelihood of hold-up problems –“narrows the market” thereby reducing competitive pressures

Asset Specificity Costs of vertical integration - Costs of outsourcing   C =  the vertical summation of the cost differences between vertical integration and reliance upon market specialists  CC Figure 4.1 K**

CC the vertical summation of  and  or production and exchange costs under vertical integration minus production and exchange costs under outsourcing Used to decide whether to “make” or “buy”

Make or Buy? If  C is positive - Buy –Costs of vertical integration > Costs of outsourcing –the firm should outsource the product If  C is negative - Make –Costs of vertical integration < Costs of outsourcing –the firm should make vertically integrate the product bringing the production in-house

Primary Implication - Asset Specificity Model as asset specificity increases firms are more likely to bring the production in-house What are other managerial implications of this model?

Managerial Implication #1 Pay attention to asset specificity –Rely on markets to produce routine, standardized or homogeneous items (market provision is best when asset specificity is low) –Produce in-house when design, engineering, production expertise, and specific investments are required (vertical integration is best when asset specificity is high)

Managerial Implication #2 Pay attention to economies of scale Rely on markets for items that require high upfront investments in physical capital or organizational capabilities that outside firms have already developed Rely on market provision when outside specialists can capture substantial economies of scale in production that you cannot –they have the advantage of aggregating demand from a number of firms/industries

Managerial Implication #3 Vertical Integration tends to be more efficient for large firms than for small firms –Vertical Integration is best when large scale in- house production is taking place –Market provision is best when in-house production is on a small scale

Managerial Implication #4 Vertical Integration is best when high coordination costs exist and Market provision is best when low coordination costs exist Technology can change coordination costs! –Technological advances have tended to lower coordination costs thereby making reliance on market production more attractive telecommunications, data processing, CAD Design, and computer-controlled machinery's

Grossman and Hart Asset Ownership and Asset Control Is the decision as to who owns the asset noncontractible or contractible? –Noncontractible decisions are RSIs which are made ex ante –Contractible decisions are operating decisions which revert to the party holding residual rights of control

Grossman and Hart Asset Ownership –affects bargaining power over operating decisions –which affects the distribution of profits or quasi-rents –which affects investment decisions –which affects the size of the total pool of profits

Grossman and Hart The form of integration between the firms affects this chain

Forms of Integration Nonintegration –firms remain independent Forward Integration - owning “upstream” –Unit 1 owns the assets of Unit 2 thus Unit 1 has control over the operating decisions of Unit 2 Backward Integration - owning “downstream” –Unit 2 owns the assets of Unit 1 thus Unit 2 has control over the operating decisions of Unit 1

Grossman and Hart Ownership of the asset or residual rights should lie with the party that has most influence on the total pool of profits.

Additional Motives for Vertical Integration To undo the effects of Imperfect Competition

Additional Motives for Vertical Integration Price Discrimination

Additional Motives for Vertical Integration To foreclose on potential competitors/entrants To avoid foreclosure by potential competitors/entrants

Additional Motives for Vertical Integration To Acquire Information

Alternative Modes of Integration Tapered Integration - “make some, buy some”

Tapered Integration Potential Benefits Expands input and/or output channels Provides a comprehensive set of cost, production, market information Can help to prevent holdup

Tapered Integration Potential Costs No one achieves full scale economies Coordination problems Monitoring and Compliance information problems –A less efficient internal production unit may be used as a benchmark for external providers –Reintroduction of agency costs associated with vertical integration - influence costs, principle agent problems

Alternative Modes of Integration Strategic Alliances –Mutual collaboration on a project Joint Ventures –Mutual collaboration on a business enterprise

Alternative Modes of Integration Collaborative Integration –Subcontracting Relationships –Keiretsu

Alternative Modes of Integration Implicit Contracts –informal, non-legalistic understandings between parties with implicit recognition of the consequences of violation on the part of each party