Vertical Boundaries of the

Firm
David Hennessy
Economics Department
1
Flow of Production
_ The production of a good or service
often requires a wide range of
activities organized in a vertical
chain.

_ Production flows from upstream to
downstream, e.g., pork,
automobiles.

_ Illustration: winemaking (slide).

_ A value chain (graph).
3The Firm and the Value Chain
^ Which portions of the chain should
the firm be involved in?

^ What is it good (bad) at? Where to
draw boundaries, and when to
change them?

^ Should a firm make or buy?
4Questionable Assertions
A: A firm should buy to avoid the costs
associated with making.

B: A firm should make in order to capture
the profits due to the input producer.

C: A firm should make in order to assure
supply and avoid fluctuating prices as
demand and supply conditions in the
input market change.

There are many such rules of thumb.
Their merit?
5Some Definitions
The value chain: This is the process
which begins with the acquisition of raw
materials and ends with the distribution
and sale of finished goods.

Segment value added: This is the
revenue associated with that segment of
the chain (graph).

Upstream (downstream) activities: These
are activities occurring early (late) in the
value chain.
6More Definitions
Support activities: These are activities not
directly associated with the transformation
of products in space, form, or time, but still
essential to the operation of the business.

Transfer price: This is a price used within a
firm that is used for pricing goods as they
move along segments of the value chain in
which the firm operates. (uses in intra-firm
make/buy decisions and in tax issues).
7Make or Buy?
Make relates to internal production.
Buy relates to use of the marketplace.
Reasons to buy:
a) economies of scale and scope,
b) market discipline.
Reasons to make:
a) coordination,
b) transactions costs,
c) information leakage.
8Reason to Buy: Scale/
Scope Economies
If the firm makes, it may not be
able to achieve the economies of
scale/scope that a market supplier
achieves.

The market supplier may have
critical mass (graph).
9Critical Mass
Key point: AC falls from Q
0
to Q
*

Average
Cost
Q
0

AC
0

Q
*

AC
*

P
10Graphic Representation: Scale
Economies
Suppose your firm needs Q
0
widgets,
and that many other firms also need
widgets.

The market firm can sell to many firms,
and it sells Q* to make average costs
very low (AC* rather than AC
0
).

The market firm can sell a widget at
price P with AC
0
> P > AC
*
, and still
make a profit.

Who benefits from the trade?
If all firms that needed Q
0
produced Q*,
then who would use the surplus?
11Scope Economies
Example: Calculators and watches.

Reason: The costs of developing and
producing the common liquid crystal
display can be spread over more output.

Other examples? Sales in Sears vs.
specialist stores. Boeing does airplanes
and aerospace. Proctor and Gamble.
12Cost Function and Scope
Economies
- Let the cost of producing Q
1
watches and
Q
2
calculators be function C(Q
1
, Q
2
).
- Produced separately, they cost
- C(Q
1
, 0) + C(0, Q
2
).
- Produced by the firm, they cost
C(Q
1
, Q
2
).
- What if
C(Q
1
, 0) + C(0, Q
2
) > C(Q
1
, Q
2
)?
- What if the reverse is true?
13 Cost Function and Scope
Economies, Contd
If your firm needs only calculators as an
input, then to compete cost-wise with a
firm producing both you may have to
produce watches too.

But you know nothing about the watch
business, and dont want to.

Punchline: Buy from the market, and
avoid the distraction.
14Origins of Scale Economies
_ Adam Smith said they came from the
division of labor.
_ The pin factory: three tasks to do;
_ a) make the head
_ b) make the spike /
_ c) solder them together

_ He found (observation) that it was less
efficient to let three people do all three jobs
than let each specialize in one of the tasks.
_ Another example: legal specialization
(graph).
15Specialization Among Lawyers

AC
Number of Lawyers in the Market
AC
General Practice Lawyers
AC
Patent Lawyers
Specialization is efficient
Specialization
not efficient
16Reason to Buy: Market
Discipline
~ The market firm may produce only one good,
focusing on the costs and quality of that
product.

~ If a firm producing other stuff decides to make
an input, then it may be for hard-to-explain
reasons (to be discussed later).

~ It may then be difficult to ascertain whether
the decision to make was wise.

~ Some insights may be obtained from agency
theory.
17The Agency Concept
O Defn: An agent is an economic entity under
formal or informal contract to provide
resources, services, or goods to another
economic entity (the principal) in return for a
(possibly outcome or environment
determined) reward.

O In the firm, the agent is generally the
employee, and the principal generally the
employer.

O The employer must guard against slack work,
and the abuse of resources for ends other
than those of the employer.
18Agency Costs
Defn: Agency costs are costs
which accrue to the principal that
are associated with insufficient or
inappropriate activities by agents,
and also the costs of guarding
against such activities.

Two examples;
a) Influence costs,
b) Innovation problems.
19Influence Costs
- Suppose a firm decides to produce an input
because no market firm can be trusted to
produce precisely what is needed, e.g. specific
software.
- Now you have employees who know more
about this input and its importance to the firm
than anyone else in the firm.
- Later, suppose you want to reassess the
decision to make. Who do you turn to? The
most knowledgeable employees have an
agenda that differs from that of the employer.
- They can not be relied upon, they may fudge
the data. This is the principal-agent problem.
- Case of unions and operations manuals.
20Innovation Costs
The firm wants to be rewarded for
successful innovations/research.

Suppose a good scientist innovates and is
rewarded with a promotion. If he/she
resigned and set up a company to exploit
the innovation, the profits might be
enormous. The firm will have to pay well to
prevent this (agency cost).

The scientist could also change jobs,
carrying the innovation. The company will
have to monitor to prevent such theft
(agency cost also).
21Reason to Make: Coordination
To produce a complicated product
cheaply, many people have to
successfully make interrelated
decisions about many resources. It is
often easier to coordinate activities
when important inputs are made inside
a firm.
Example: a restauranteur who needs
waiters and chefs to coordinate. Best
to hire nightly longer-term?
22Types of Coordination Costs
Time: Release movies on time after
advertizing, software, microchips, books
(on death of celebrity).

Size: The space shuttle disaster of 1986
may have been caused by an ill-fitting O-
ring.

Color: Benetton needs the colors it uses to
be fashionable at the time.

Sequence: Coordinating sequence is vital
on assembly lines and in sports.
23Reason to Make: Transactions
Costs
There are costs associated with
organizing and transacting exchanges
between arms-length firms in the
marketplace..

Such costs include negotiating, writing,
and enforcing contracts. Consumes
expensive management time.
24Reason to Make: Information
Leakage
' Firms usually have sensitive private
information concerning innovations, sales,
strategies, financial status etc.

' Employers may be easier to keep quiet than
outside firms who might have to be given
access to this information to do their job.

' Examples: Coke and its secret formula;
mining firms use their own geologists;
Chinese Wall.
25Assertions T/F?
A: A firm should buy to avoid the costs
associated with making? Depends on
price, quality and other issues.

B: A firm should make in order to capture
the profits due to the input producer?
Depends on cost structure etc.

C: A firm should make in order to assure
supply and avoid fluctuating prices?
Might a production contract or use of
futures markets (buying price stability) be
less costly?