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Vertical Integration

EMGT 722
November 14, 2009
THE FOLLOWING PRESENTATION HAS BEEN RATED

SF Stossel-Free
Why are We Talking About This?
Vertical Integration in the News
And, Finally

Recognize this dude?


Recognizing Vertical Integration

?
Recognizing Vertical Integration

?
Recognizing Vertical Integration

?
Recognizing Vertical Integration

?
Value Chain

Firm Infrastructure

Human Resource Management

Technological Development

Procurement

Service
Operations

Outbound Logistics
Inbound Lo

Marketing and Sales


Primary Activities
s
ogistics

Forward Integration
Backward Integration
Vertical Integration Decisions

Which steps of the chain are to be


performed inside the firm?

Which steps of the chain to be out-


sourced?

Choice between the invisible


invisible hand
hand of the
market and the visible hand of the
organization
Lets Play a Game

Pair up with another student

O
One off you is
i buyer
b and
d th
the other
th
supplier
Assign alphabetically
Da Rules
1. Buyer decision #1: Invest or Not
Buyer has an opportunity to make an investment that will
save $1
$1,500
500 in the long term
term.
Investment costs $500 and is only useful in conjunction with
the one Supplier.
Buyer is potentially $1
$1,000
000 better off by deciding to invest
invest,
provided that he/she continues the business relationship with
the Supplier.
2. Supplier decision: Raise price or Not
Supplier has an opportunity to raise price by $750, knowing
that the Buyer has made a net saving of $1,000 and can
therefore afford to pay more.
3. Buyer response: Keep or fire supplier
If price increase, buyer may change suppliers
Buyer ends up $500 worse off due to the wasted investment
Supplier ends up $1,000 worse off due to the loss of business from
the Buyer.
Scenarios
New Scenario
Now rather than saving the buyer $1,500, the investment
saves $
$1,000
, ((so net g
gain of $
$500 after $
$500 cost))
Vertical Integration
and
Transaction Costs
Forms of Economic Organization

O
Organizational
i ti l Form
F Continuum
C ti

Market (Alliances) Firm


(transaction costs) (administrative costs)

Tradeoff between market transaction costs and


firm administrative costs
Make vs. Buy
Which is better?
Of course, the answer
is It Depends
Decision depends on
the costs and benefits
MAKE Buy
of using the market vs.
performing
p g the task in-
house
Firm Boundaries: Costs & Benefits
Firms Markets
Administration. Costs Search costs locating a
Costs increase as more supplier
heterogeneous
Opportunism
pp self interest
seeking w/ guile
Fixed costs may reduce
flexibility in changing market Taxes and regulations
conditions

Build new capabilities. Retain EoS >> lower prices


Benefits competence. Competitive supply >> lower
prices
Control opportunistic behavior Flexibility for demand
from greater incentive
alignment uncertainty
True or False?

Firm should make rather than buyy assets that


provide competitive advantages
Outsourcing an activity eliminates the cost of
that
h activity
i i
Backward integration captures the profit margin
of the supplier
Backward integration insures against the risk of
high
g input
put pprices
ces
It makes sense to tie up the distribution channel
in order to deny access to the rivals
Why Buy (Outsource)?

Potential for lower costs

Market discipline (high


(high-powered
powered
incentives)

Trying to consolidate cultures can be a


disaster
Why Make?

Concern over proprietary technologies

Coordination
C di ti costst

Other transaction costs might be high

These problems are driven by difficulties in


contracting
Information Sharing Risks

Relying
Relying on outside suppliers is not a
game for the nave player. It demands
careful study
study. If you bungle a relationship
with the Japanese, you can lose your
technology your business
technology, business.
Roger Levin, VP of Technology &
Development Xerox
Development,
Contracting

Whats the purpose of contracts?


Contracting

Contracts protect each party to a transaction


from opportunistic behavior by the other

Contracts ability to provide this protection


depends
p on
the completeness of contracts
co
contract
t act law
a
Complete Contracts
A complete contract stipulates what each party
should do for every possible contingency

So, no opportunity to exploit weakness after the


fact

What you need for a complete contract


Perfect foresight, mapping, measurement,
enforceability
Why are Contracts Incomplete?

People
p are boundedly
y rationalityy

Its difficult to specify


p y and measure p
performance

Parties have different levels of information


(asymmetric information)

Enforcement
E f li i i
limitations
Transaction Costs and Contracting

Types of transactions costs


Search costs
Costs of negotiating, writing and enforcing contracts

Sources
S off transactions
t ti costs
t
Small numbers of players (hard to find right partner)
Investments that need to be made in relationship-specific assets
Possible opportunistic behavior after the investment is made
(hold up problem)

Transactions costs explain why activities are brought


inside the firm
When are Market Transactions Costly

Costly Transactions

Hard to allay
Costly to find a
concerns of being
trading partner
taken advantage of

Buyer and seller


Costly to write Contracts, property
have different
a contract rights not enforced
info

Long-term Relationship-
Unclear property
relationships, specific
rights
dynamic settings investments

Source: Anand, Khanna & Rivkin (2000)


Caveat

I am not advocating g that yyou behave


opportunistically in your contractual relations

I do
d want you to b
be aware that
h there
h are
some people out there who will behave this
way, and you should protect yourself

Also,, note that concerns over opportunism


pp
may relate to culture and other factors that
increase the penalty for bad behavior
Different Types of Specificity

Site specificity

Physical
Ph i l assett specificity
ifi it

Dedicated assets

Human asset specificity


Holdup and Contracting

Potential for holdup raises the cost of transacting

In worst case,
case potential for holdup leads to total
unwillingness to invest in relationship-specific
assets
Remember our Game

In Scenario 1, you lose some of the gains


from your investment because its
pp p
supplier-specific

In Scenario 2, the potential for hold-up


hold up
totally deters the transaction

Vertical integration allows you to capture


the gains
How Vertical Integration Solves Holdup

The Power of fiat

It introduces a repeated
repeated relationship
relationship that
reduces uncertainty and makes relationship-
specific
p investment more pprofitable

Itt may
ay a
allow
o oorganizational
ga at o a cu culture
tu e to p
promote
o ote a
an
atmosphere of cooperation
Bad Reasons for Vertical Integration

Reducing cyclicality or volatility in earnings

Assuring
A i supply
l

Moving closer to the customer

Source: Stuckey and White (1993)


Rule of Thumb

Do it in the market
Unless there are compelling reasons to bring the
transaction within the firm

The presence of transaction costs is a major


reason for bringing transactions within the
firm

Transaction costs are often driven by


presence of asset specificity
More Motives for
Vertical Integration
More Motives

Gaining Market Power


Market Development
E di R
Evading Regulation
l ti
Eliminating Double Markup
Aligning Incentives
Engaging in Price Discrimination
Gaining Market Power

Vertical integration
g MAY allow yyou to tie up
p necessary
y
inputs or means of distribution

Vertical integration may also raise entry barriers if new


entrants have to be integrated to compete

Caveat: Do NOT buy a customer or supplier simply


because they are profitable

Buy only if you can enter for less than the capitalized
value of future profits
Evading Regulation Motive

One of the simplest and easiest


easiest-to-understand
to understand
reasons for vertical integration

Example: Rent Control

Example: Multi-National Companies


Solving the Double-Markup Problem

Example: Gasoline refiners selling branded


gasoline

What is the double markup problem?

How does vertical integration solve this?


Aligning Retailer Incentives with
Manufacturer
a u actu e Goa
Goalss

Example: Getting retailers to invest in demand


demand-
enhancing services

Limiting intra-brand competition also helps


reduce free-riding

Many of these tactics may be illegal under


antitrust
tit t laws
l ((especially
i ll for
f companiesi with
ith
dominant market shares)
Price Discrimination

Two separate
p consumer g
groups
p who use same
product in different manners

How can vertical integration foster price


discrimination?

Example: Herbicide users (home gardeners and


farmers)

Price discrimination at the wholesale level is much


more difficult (and may be illegal)

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