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Vertical Scope of the Firm What are the appropriate (efficient) organizational boundaries of the Vertical Scope of the Firm What are the appropriate (efficient) organizational boundaries of the firm?

Transaction Costs and the Scope of the Firm In relation to each dimension of Transaction Costs and the Scope of the Firm In relation to each dimension of scope, the basic issue is relative efficiency of the single firm compared with several specialist firms. VERTICAL SINGLE FIRM SEVERAL SPECIALIZED FIRMS PRODUCT V 1 V 2 V 3 P 1 P 2 P 3 V 1 V 2 P 1 GEOGRAPHICAL AREAS A 1 A 2 A 3 P 1 A 2 A 3 V 3 Common Issue: What are transactions costs of markets compared with administrative/governance costs of the firm? Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Vertical Scope of the Firm Voigt, Fall, 1998

Creating Efficiently Designed Corporations The corporate hierarchy will be efficient when it can be Creating Efficiently Designed Corporations The corporate hierarchy will be efficient when it can be shown to be the organizational arrangement that minimizes the sum of production and governance costs. Production costs are the direct costs incurred in the physical production and exchange of the item subject to the transaction. Governance costs include costs of negotiating, writing, monitoring, enforcing, and possibly also bonding to the terms of the organizational arrangement. Historically, production costs were the primary drivers of firm boundaries. More recently, attention has been placed on governance costs. Source: Collis and Montgomergy, Corporate Strategy, 1997 Vertical Scope of the Firm Voigt, Fall, 1998

Defining Vertical Integration Vertical integration (VI) is a firm’s ownership of vertically related activities. Defining Vertical Integration Vertical integration (VI) is a firm’s ownership of vertically related activities. Vertical integration can occur in 2 directions: • Backward Integration (producing own inputs) • Forward Integration (disposing of own outputs) Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Vertical Scope of the Firm Voigt, Fall, 1998

Benefits of Vertical Integration Economies of combined operations Economies of internal control and coordination Benefits of Vertical Integration Economies of combined operations Economies of internal control and coordination Assure supply or demand Better quality control and coordination Protect proprietary technology Gain access to information Avoid costs of dealing with the market Gain (or offset) market power Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Vertical Scope of the Firm Voigt, Fall, 1998

The Costs of Vertical Integration Differences between stages in optimal scale of operation Managing The Costs of Vertical Integration Differences between stages in optimal scale of operation Managing strategically different businesses Agency costs Higher capital investment Reduced Flexibility • in responding to demand uncertainty • in responding to changes in technology, customer preferences, etc. Foreclose access to outside information/technology Dulled incentives Costs of bureaucratic hierarchy Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Vertical Scope of the Firm Voigt, Fall, 1998

Benefits of the Market Informational efficiencies i. e. price mechanisms and decentralized decision-making Powerful Benefits of the Market Informational efficiencies i. e. price mechanisms and decentralized decision-making Powerful incentive mechanisms i. e. better alignment self-interested behavior and incentives e. g. Direct production costs of individual proprietors transacting with one another on the market will be lower than those involving employees inside a corporate hierarchy. Source: Collis and Montgomery, Corporate Strategy, 1997 Vertical Scope of the Firm Voigt, Fall, 1998

Costs of the Market: Transaction Costs and Market Failures Market relationships fail when they Costs of the Market: Transaction Costs and Market Failures Market relationships fail when they are subject to: • Opportunism (lying, cheating, stealing, acting self-interestedly) • Asset specificity (small numbers) (Location specificity, physical asset specificity, and human asset specificity) • Uncertainty (inability to predetermine all future eventualities) • High Frequency (repeated exposure to hold up) It is the possibility of firms acting opportunistically that causes market failure. The other three conditions create the opportunity for a firm to act opportunistically. • Other Sources include resource inseparability, information impactedness, and market power Source: Collis and Montgomery, Corporate Strategy, 1997 Vertical Scope of the Firm Voigt, Fall, 1998

The Choice between Market and Hierarchy MARKET HIERARCHY Informational Efficiencies BENEFITS Authority High-Powered Incentives The Choice between Market and Hierarchy MARKET HIERARCHY Informational Efficiencies BENEFITS Authority High-Powered Incentives Coordination Bureaucracy Market Power COSTS Transaction Costs Agency theory Source: Collis and Montgomery, Corporate Strategy, 1997 Vertical Scope of the Firm 9 Voigt, Fall, 1998

Factors that are important in determining the merits of vertical integration compared to market Factors that are important in determining the merits of vertical integration compared to market transactions How many firms are there in the vertically related activity? The fewer the companies, the greater the attraction of VI. Do transactions-specific investments need to be made by either party? The greater the requirements for specific investments, the more attractive is VI. Does limited availability of information provide opportunities to the contracting firm to behave opportunistically (i. e. , cheat)? The greater the difficulty of specifying and monitoring contracts, the greater the advantages of VI. Are market transactions subject to taxes and regulations? VI is attractive if it can circumvent taxes and regulations. How much uncertainty exists with regard to the circumstances prevailing over the period of the contracts? Uncertainty raises the costs of writing and monitoring contracts, and provides opportunities for cheating, therefore increasing the attractiveness of VI. Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Vertical Scope of the Firm 10 Voigt, Fall, 1998

Factors that are important in determining the merits of vertical integration compared to market Factors that are important in determining the merits of vertical integration compared to market transactions How uncertain is market demand? The greater the demand uncertainty-the more costly is VI. Are the two stages similar in terms of the optimal scale of operations? The greater the dissimilarity in scalethe more difficult is VI. How strategically similar are the different stages in terms of key success factors and the resources and capabilities required for success? The greater the strategic dissimilarity the more difficult is VI. Does VI increase risk through requiring The heavier the investment heavy investments in multiple stages requirements and the greater the and compounding otherwise independent risks at each stage --the independent risk factors? more risky is VI. Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Vertical Scope of the Firm 11 Voigt, Fall, 1998

Intermediate Forms of Organization: A Continuum of Governance Arrangements RANGE OF INTERMEDIATE FORMS SPOT Intermediate Forms of Organization: A Continuum of Governance Arrangements RANGE OF INTERMEDIATE FORMS SPOT MARKET LONG-TERM CONTRACTS STRATEGIC ALLIANCES JOINT VENTURES QUASIVERTICAL INTEGRATION (PARTIAL OWNERSHIP) INTERNAL HIERARCHY (full integration) Intermediate relationships may combine the benefits of both market transactions and internalization Vertical Scope of the Firm Voigt, Fall, 1998

Different Types of Vertical Relationships Low Degree of Commitment Formalization Low High Informal supplier/ Different Types of Vertical Relationships Low Degree of Commitment Formalization Low High Informal supplier/ customer relationships High Vertical integration Supplier/ customer partnerships Spot sales/ purchases Joint ventures Agency agreements Long-term contracts Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Franchises Vertical Scope of the Firm Voigt, Fall, 1998

Designing Vertical Relationships: Long-Term Contracts and Quasi-Vertical Integration Intermediate between spot transactions and vertical 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? Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Vertical Scope of the Firm Voigt, Fall, 1998

Recent Trends in Vertical Relationships (US) From competitive contracting to supplier partnerships (e. g. Recent Trends in Vertical Relationships (US) From competitive contracting to supplier partnerships (e. g. auto industry). From vertical integration to outsourcing (not just components, also IT, distribution, and administrative services). Diffusion of franchising. Technology partnerships (e. g. IBM-Apple; Canon-HP). Inter-firm networks. General conclusion: Boundaries between firms and markets becoming increasingly blurred. Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995 Vertical Scope of the Firm Voigt, Fall, 1998

JAPANESE APPROACH Extensive use of subcontracting Mitigate opportunism via: equity links personnel links long-term JAPANESE APPROACH Extensive use of subcontracting Mitigate opportunism via: equity links personnel links long-term relationships implicit contracts Close coordination of suppliers and assemblers product design JIT delivery • • • Source: Mari Sakakibara, UCLA, 1997 Vertical Scope of the Firm Voigt, Fall, 1998

Flow Chart for Vertical Integration Decisions MARKET CONTRACT YES INCENTIVES AGENCY COSTS RENT APPROPRIABILITY Flow Chart for Vertical Integration Decisions MARKET CONTRACT YES INCENTIVES AGENCY COSTS RENT APPROPRIABILITY NO HOLD-UP TRANSACTION COSTS NO TRADEOFF COORDINATION FIAT YES INSIDE HIERARCHY YES Vertical Scope of the Firm 17 Voigt, Fall, 1998

Action Steps in Scope of Firm Decisions Step 1: Disaggregate the Industry Value Chain Action Steps in Scope of Firm Decisions Step 1: Disaggregate the Industry Value Chain Step 2: Competitive Advantage – Do you have a competitive advantage in the performance of the activity? Step 3: Market Failure – Is there a clear market failure? Are the costs of market governance extremely high? Can dominant firms exercise market power? Step 4: Need for Coordination – Is there an ongoing need for intensive coordination? Are continual and integrated changes required? Is there a distinct interface between activities? Source: Collis and Montgomery, Corporate Strategy, 1997 Vertical Scope of the Firm Voigt, Fall, 1998

Action Steps (cont’d) Step 5: Importance of Incentives – How high are agency costs Action Steps (cont’d) Step 5: Importance of Incentives – How high are agency costs inside the hierarchy? How much do worker skill and effort affect outcomes? Can an effective incentive scheme be designed? Which is more important: coordination or high-powered incentives? Source: Collis and Montgomery, Corporate Strategy, 1997 Vertical Scope of the Firm Voigt, Fall, 1998

Summary: Creating Value in Vertical Activities Be Better Than Competitors (1) In determining whether Summary: Creating Value in Vertical Activities Be Better Than Competitors (1) In determining whether activities should be internal or external: External Supplier (2) Internal Activities External Customer In coordinating these activities along the value chain: Vertical Scope of the Firm 20 Voigt, Fall, 1998

General Conclusion Ross Perot to GM Management: “You don’t need to own a dairy General Conclusion Ross Perot to GM Management: “You don’t need to own a dairy to buy milk. ” Vertical Scope of the Firm Voigt, Fall, 1998