1. The Vertical Boundaries of the Firm  Upstream, Downstream  Defining Boundaries  Benefits and Constraints of Using the Market  Information Asymmetry  The Nature of the Firm  Organizing Vertical Boundaries of the Firm  Technical Efficiency and Agency Efficiency  Asset Ownership and Vertical Boundaries of the Firm

2. Upstream, Downstream Any firm’s activity is part of a vertical chain in a particular industry or economic sector. Any firm’s activity is part of a vertical chain in a particular industry or economic sector. Goods “flow” in any economy within different vertical chains, where raw materials at manufacturing level become finished goods distributed and retailed to final customers. Goods “flow” in any economy within different vertical chains, where raw materials at manufacturing level become finished goods distributed and retailed to final customers. Vertical chains are processes where added value is being generated at each step, i.e. manufacturing, distribution and retailing. Economists argue that “early steps are upstream in the production process, and later steps are downstream (…).”[i] [i] Besanko, David; Dranove, David; Shanley, Mark. “Economics of Strategy”, p. 71, New York: John Wiley & Sons, Inc. 1986 Vertical chains are processes where added value is being generated at each step, i.e. manufacturing, distribution and retailing. Economists argue that “early steps are upstream in the production process, and later steps are downstream (…).”[i] [i] Besanko, David; Dranove, David; Shanley, Mark. “Economics of Strategy”, p. 71, New York: John Wiley & Sons, Inc. 1986[i]

3. Any firm has four decision choices, as follows:   Going upstream along the vertical chain,   Performing downstream along the vertical chain,   Having “in-house” professional supporting activities,   Buying professional supporting activities from a  market firm. The four decision choices form the “make-or-buy” decision framework. A good manager should make the right decision according to firm’s unique capabilities. Going upstream or downstream is a strategic choice that any organizational leader should make based on firm’s unique capabilities.

4. Defining Boundaries A firm must decide whether it needs to use the market or performing the activity in-house. Firm’s boundaries are determined by “the capabilities of the firm relative to the capabilities of the market.”[i] In the long run, if the costs of using firm’s capabilities exceed the benefits, the firm will have to find alternative ways by buying specialized supporting activities from a market firm. A firm must decide whether it needs to use the market or performing the activity in-house. Firm’s boundaries are determined by “the capabilities of the firm relative to the capabilities of the market.”[i] In the long run, if the costs of using firm’s capabilities exceed the benefits, the firm will have to find alternative ways by buying specialized supporting activities from a market firm.[i] In the same way, on the long run, if the costs of using market’s capabilities are greater than the benefits, the firm will have to develop its in-house capabilities. In the same way, on the long run, if the costs of using market’s capabilities are greater than the benefits, the firm will have to develop its in-house capabilities. The organizational abilities of maximizing potential benefits of using either in-house capabilities or professional supporting activities from market firms are factors that shape firm’s boundaries. The organizational abilities of maximizing potential benefits of using either in-house capabilities or professional supporting activities from market firms are factors that shape firm’s boundaries. [i][i] Langlois, R. N., & Robertson, P. L. 1995. “Firms, Markets and Economic Change: A Dynamic Theory of Business Institutions”, London: Routledge, p. 33 [i]

5. Benefits and Constraints of Using the Market Benefits of Using the Market Benefits of Using the Market Organizations use market firms when the potential benefits of “employing” market’s capabilities are greater than its incurring costs. Moreover, firms use the market if they “can take advantage of the hard- edged incentives that only the market can offer.”[i] [i] Besanko et al. Op. cit., p. 77 Organizations use market firms when the potential benefits of “employing” market’s capabilities are greater than its incurring costs. Moreover, firms use the market if they “can take advantage of the hard- edged incentives that only the market can offer.”[i] [i] Besanko et al. Op. cit., p. 77[i] Here are some potential advantages of using the market: - “Market firms can achieve economies of scale.”[i] [i] Ibid. p. 77 [i] - “Market Firms are Subject to the Discipline of the Market”[i] [i] Ibid. p. 84 [i] Organizational leaders should be aware of market’s capabilities that might be used for the business. The leaders should, also, be aware of the additional costs that might occur when the effort paid for using those market capabilities become greater than the cost paid for using the organizational capabilities. Organizational leaders should be aware of market’s capabilities that might be used for the business. The leaders should, also, be aware of the additional costs that might occur when the effort paid for using those market capabilities become greater than the cost paid for using the organizational capabilities.

6. Information Asymmetry The information is asymmetric when one or more parties in a contract or organizational context have more or better information than the other one(s). The information is asymmetric when one or more parties in a contract or organizational context have more or better information than the other one(s). The CEO of a complex organizational structure may face the risk of not having access to the correct information or the information provided is not reflecting the real “picture”. The CEO of a complex organizational structure may face the risk of not having access to the correct information or the information provided is not reflecting the real “picture”. The decision making process is, sometimes, a multistage process with the information being, firstly, received by the division-level management and, then, communicated to upper managerial level. The information might be distorted when there is a multistage decision making process. The decision making process is, sometimes, a multistage process with the information being, firstly, received by the division-level management and, then, communicated to upper managerial level. The information might be distorted when there is a multistage decision making process. There are voices arguing that it might be a sort of distorted competition, i.e. competition between more than one organizational divisions for influencing the distribution of benefits within the organization. There are voices arguing that it might be a sort of distorted competition, i.e. competition between more than one organizational divisions for influencing the distribution of benefits within the organization. It is the influence cost that is made out of the followings: It is the influence cost that is made out of the followings: - “Direct costs of influencing the activities (e.g., the time consumed by a division manager lobbying central management to overturn a decision that is unfavorable to his or her division ).”[i] - “Direct costs of influencing the activities (e.g., the time consumed by a division manager lobbying central management to overturn a decision that is unfavorable to his or her division ).”[i][i] [i] Besanko et al. Op. cit., p. 87 [i] - “The costs of bad decisions that arise from influence activities (…).”[i] [i] [i] Ibid. p. 87 [i]

7. Costs of Using the Market A. Coordination of decision flows through the vertical chain. Successful decision-making process through the vertical chain, influencing the flows of information and material resources, depends on: A. Coordination of decision flows through the vertical chain. Successful decision-making process through the vertical chain, influencing the flows of information and material resources, depends on: Efficient coordination between the different steps within the vertical chain. B. “Leakage of Private Information” Firms risk loosing private information when making contractual arrangements with market firms. B. “Leakage of Private Information” Firms risk loosing private information when making contractual arrangements with market firms. C. Transaction Cost. It is a “cost incurred in making an economic exchange.”[i] [i] Wikipedia – The Free Enciclopedia, 2005. Available from: http://en.wikipedia.org/wiki/Transaction_cost C. Transaction Cost. It is a “cost incurred in making an economic exchange.”[i] [i] Wikipedia – The Free Enciclopedia, 2005. Available from: http://en.wikipedia.org/wiki/Transaction_cost[i]

8. The Nature of the Firm Why firms exist? Wouldn’t be more appropriate to have contractual arrangements between self-employed persons? Why firms exist? Wouldn’t be more appropriate to have contractual arrangements between self-employed persons? “(…) search and information costs, bargaining costs, keeping trade secrets, and policing and enforcement costs” are all different kinds of transaction costs. These all add up to the initial cost of goods of services. Firms emerge when the production of certain goods or services might be performed internally and, consequently, having some transaction costs reduced. “(…) search and information costs, bargaining costs, keeping trade secrets, and policing and enforcement costs” are all different kinds of transaction costs. These all add up to the initial cost of goods of services. Firms emerge when the production of certain goods or services might be performed internally and, consequently, having some transaction costs reduced. Company grows as a result of “finding the optimal balance between the competing tendencies of the costs outlined above.”[i] [i] Ibid. Company grows as a result of “finding the optimal balance between the competing tendencies of the costs outlined above.”[i] [i] Ibid.[i] There might be several stages of firm’s life as outlined bellow: There might be several stages of firm’s life as outlined bellow:  The first stage occurs when firms actually emerge due to a more efficient use of internal resources. At this stage, some transaction costs might be avoided by choosing to produce a certain product “in-house” instead of having it supplied based on a contractual arrangement in the market.  The first stage occurs when firms actually emerge due to a more efficient use of internal resources. At this stage, some transaction costs might be avoided by choosing to produce a certain product “in-house” instead of having it supplied based on a contractual arrangement in the market.  The second stage takes place when the firm grows. It means that the company found out the optimal balance between the two competing categories of costs, i.e. transaction cost and the cost associated with “decreasing returns to the entrepreneur function”.  The second stage takes place when the firm grows. It means that the company found out the optimal balance between the two competing categories of costs, i.e. transaction cost and the cost associated with “decreasing returns to the entrepreneur function”.

9.  The third stage occurs when the firm reached its peak and started to fall. At this stage the costs associated with “decreasing returns to the entrepreneur function”[i] started to overcome the transaction costs. The firm reached an adjourning phase. The growing phase reached a peak and firm move to a decreasing phase.  The third stage occurs when the firm reached its peak and started to fall. At this stage the costs associated with “decreasing returns to the entrepreneur function”[i] started to overcome the transaction costs. The firm reached an adjourning phase. The growing phase reached a peak and firm move to a decreasing phase.[i] [i] Ibid. [i] Firms exist because the conditions of a competitive market are reproduced within the organization at a lower cost comparing to market conditions. Firms exist because the conditions of a competitive market are reproduced within the organization at a lower cost comparing to market conditions. Managing long-term contract arrangements with different stakeholders create the conditions for cost savings due to cost redistribution on a portfolio of long-term contracts. Managing long-term contract arrangements with different stakeholders create the conditions for cost savings due to cost redistribution on a portfolio of long-term contracts.

10. Organizing Vertical Boundaries of the Firm Firms can either choose to organize in-house required supportive operations or enter into market transactions with specialized organizations supplying certain specialized functions. Organizations can, also, integrate some or all of its supportive functions along its vertical chain. Firms can either choose to organize in-house required supportive operations or enter into market transactions with specialized organizations supplying certain specialized functions. Organizations can, also, integrate some or all of its supportive functions along its vertical chain. Companies choosing to organize one or more specialized supportive functions internally are advantaged in terms of costs relative to the situation when they would have rather chosen to enter into transactions with a specialized market firm. The reason is that the perceived cost related to the developing and organizing some supportive functions (e.g. HR and accounting) is less than the cost paid for specialized services provided by market firms. Companies choosing to organize one or more specialized supportive functions internally are advantaged in terms of costs relative to the situation when they would have rather chosen to enter into transactions with a specialized market firm. The reason is that the perceived cost related to the developing and organizing some supportive functions (e.g. HR and accounting) is less than the cost paid for specialized services provided by market firms. On the other hand, firms choosing to have some supportive functions supplied by specialized market firms are advantaged in terms of costs comparing with the effort paid for having these specialized functions developed and organized “in-house”. On the other hand, firms choosing to have some supportive functions supplied by specialized market firms are advantaged in terms of costs comparing with the effort paid for having these specialized functions developed and organized “in-house”. The decision to either have some functions outsourced or organized internally depends on the cost advantage of each option related to the other. The decision to either have some functions outsourced or organized internally depends on the cost advantage of each option related to the other.

11. Technical Efficiency and Agency Efficiency Technical Efficiency A firm is technically efficient when using “the least-cost production process.”[i]. A firm is technically efficient when using “the least-cost production process.”[i].[i] –Example: Some successful retailers are technically efficient as they managed to use the least-cost sourcing and selling processes. Value-for-money retailers secured their profit margins by using the least-cost sourcing and selling processes and capabilities. [i][i] Besanko et al. Op. cit., p. 134 [i] Agency Efficiency “Agency efficiency refers to the extent to which the exchange of goods and services in the vertical chain has been organized to minimize the coordination, agency, and transaction costs (…)”[i] “Agency efficiency refers to the extent to which the exchange of goods and services in the vertical chain has been organized to minimize the coordination, agency, and transaction costs (…)”[i][i] [i] Besanko et al. Op. cit., p. 134 [i] Firms failing to minimize transaction costs do not achieve agency efficiency.[i] Failing to achieve agency efficiency is similar to failing to manage efficiently the exchange process of goods and services along the vertical chain. [i] See Besanko et al. Op. cit. Firms failing to minimize transaction costs do not achieve agency efficiency.[i] Failing to achieve agency efficiency is similar to failing to manage efficiently the exchange process of goods and services along the vertical chain. [i] See Besanko et al. Op. cit.[i]

12. Asset Ownership and Vertical Boundaries of the Firm Owning assets and controlling different steps along the vertical chain can make the difference comparing vertical integration with market exchange. Some firms expanded vertically by taking control on other firm’s assets or creating their own capabilities positioned upstream or downstream within the vertical chain. Owning assets and controlling different steps along the vertical chain can make the difference comparing vertical integration with market exchange. Some firms expanded vertically by taking control on other firm’s assets or creating their own capabilities positioned upstream or downstream within the vertical chain. –For example, PepsiCo developed relations with two types of bottlers, i.e. independent bottlers and company-owned bottlers. PepsiCo has no direct control over an independent bottler’s management. PepsiCo can, also, acquire one of its independent bottlers. In this final case, PepsiCo has direct control over the management of the newly acquired bottler.[i] [i] [i] Ibid. [i] “Sanford Grossman and Oliver Hart analyze three different organizational arrangements: “Sanford Grossman and Oliver Hart analyze three different organizational arrangements:  Nonintegration  Nonintegration  Forward integration  Forward integration  Backward integration.”[i]  Backward integration.”[i][i][i]

13. - Nonintegration refers to the situation when two units, unit 1 being upstream of unit 2, are independent firms, each one being in control of its own assets. - Nonintegration refers to the situation when two units, unit 1 being upstream of unit 2, are independent firms, each one being in control of its own assets. - Forward integration: unit 1 owns the assets of unit 2: “unit 1 forward integrates into the function performed by unit 2 by purchasing control over unit 2’s assets”.[ii] - Forward integration: unit 1 owns the assets of unit 2: “unit 1 forward integrates into the function performed by unit 2 by purchasing control over unit 2’s assets”.[ii][ii] - Backward integration: unit 2 owns the assets of unit 1: “unit 2 backward integrates into the function performed by unit 1 by purchasing control over unit 1’s assets”[iii]. - Backward integration: unit 2 owns the assets of unit 1: “unit 2 backward integrates into the function performed by unit 1 by purchasing control over unit 1’s assets”[iii].[iii] [i][i] Besanko et al. Op. cit., p. 144 [ii] Ibid., p. 144 [iii] Ibid., p. 144 [ii][iii] [i][ii][iii] In conclusion, firms’ decision processes depend on the way assets are owned and controlled by different units regarded as organizations performing different steps along the vertical chain.