1. Vertical Integration and The Scope of the Firm
OUTLINE
Transactions Costs and the Scope of the Firm
--Why does the firm exist?
--The trend over time
The Costs and Benefits of Vertical Integration
Designing Vertical Relationships: Long-term Contracts and Quasi-Vertical Integration
Recent Trends 33

2. From Business Strategy to Corporate Strategy: The Scope of the Firm
Business Strategy is concerned with how a firm competes within a particular market
Corporate Strategy is concerned with where a firm competes the scope of its activities
The dimensions of scope are
geographical scope
vertical scope
product scope 34

3. Changes in Aggregate Concentration Over Time
50%
Sales of 100 biggest cos. as % of US industrial output
35%
20%
Since early 19th century, firms have grown in size
Alfred Chandler points to growing vertical, geographical and product scope of industrial companies
What factors explain this trend?
Why has the trend reversed since the late 1970s? 37

4. Transactions Costs and the Scope of the Firm
Which is more efficient : several specialist firms linked by markets, or the combination of these specialist firms under common ownership.
VERTICAL PRODUCT GEOGRAPHICAL
AREAS
SINGLE V P1 P2 P A1 A2 A3
FIRM V2 V3
SEVERAL V P1 P P A1 A2 A3
SPECIALIZED V2
FIRMS V3
Common Issue--- What are TRANSACTION COSTS of markets compared with administrative costs of the firm? 35

5. Transactions Costs and The Existence of the Firm
Transaction cost theory explains not just the boundaries of firms, also the existence of firms.
In 18th century English woolen industry, no firms -- independent spinners, weavers, and merchants.
Residential remodeling industry -- mainly independent self-employed builders, plumbers, electricians, painters.
Key issue -- transaction costs of the market vs. administrative costs of firms.
Note: transaction costs = cost of locating, negotiating, and enforcing a contract. 36

6. What would happen if all transactions were done through the market?
Why do firms exist?
What would happen if all transactions were done through the market?

7. Transaction Cost Economics (TCE) Framework
Opportunism
Bounded rationality
Asset Specificity
Uncertainty
Frequency
Transaction Costs

8. Determinants of Changes in Corporate Scope: 1800-1975
Expansion in size & scope
Advances in transportation, information and communication technologies
Advances in management - accounting systems, decision sciences, financial techniques, organizational innovations, scientific management 38

9. Determinants of Changes in Corporate Scope1975-2000
Contraction in size & scope
Increased market turbulence, more competition, accelerated technological change
Need for speed, flexibility, responsiveness
Large, complex corporations become relatively less efficient 38

10. The Costs and Benefits of Vertical Integration: BENEFITS
Technical economies from integrating processes e.g. iron and steel production
-- but doesn’t necessarily require common ownership
Superior coordination
Avoids transactions costs of market contracts from:
-- small numbers of firms
-- transaction-specific investments
-- opportunism and strategic misrepresentation
-- taxes and regulations on market transactions 39

11. The Costs and Benefits of Vertical Integration: COSTS
Loss of high-powered incentives
Differences in optimal scale of operation between different stages prevents balanced VI
Strategic differences between different vertical stages creates management difficulties
Inhibits development of and exploitation of core competencies
Limits flexibility -- in responding to demand cycles
-- in responding to changes in technology,
customer preferences, etc.
(But VI may be conducive to system-wide flexibility)
Compounding of risk 40

12. When is Vertical Integration More Attractive than Outsourcing?
How many firms are available The fewer the companies
to undertake the activities? the more attractive is VI
Is transaction-specific investment If yes, VI more attractive needed?
Does limited information permit VI can limit opportunism cheating?
Are taxes or regulation imposed VI can avoid them on transactions?
Do the two stages have similar Greater the similarity, the optimal scale of operation? more attractive is VI
Are the two stages strategically Greater the strategic similar? similarity ---the more attractive is VI
How uncertain is market demand? Greater the unpredictability the more costly is VI
Does VI increase risk? If heavy investment required and risks between stages are inter related----VI increases risk.

13. Designing Vertical Relationships: Long-Term Contracts and Quasi-Vertical Integration
Intermediate between spot transactions and vertical integration are several types of vertical relationships
---such relationships may combine benefits of both market transactions and internalization
Key issues in designing vertical relationships
-- How is risk allocated between the parties?
-- Are the incentives appropriate? 41

14. Recent Trends in Vertical Relationships
From competitive contracting to supplier partnerships, e.g. in autos
From vertical integration to outsourcing (not just components, also IT, distribution, and administrative services).
Technology partnerships (e.g. IBM- Apple; Canon- HP)
Inter-firm networks
General conclusion:- boundaries between firms and markets becoming increasingly blurred. 42

15. Different Types of Vertical Relationship
Low Degree of Commitment High
Low
Informal supplier/ customer relationships
Vertical integration
Supplier/ customer partnerships
Spot sales/ purchases
Formalization
Joint ventures
Agency agreements
Franchises
Long-term contracts
High 3