Week 2 - Vertical Boundaries of the Firm

Question 1

Why is organising the value chain an important part of business strategy? (Part 1)

Answer 1

• Production of any good/service requires wide range of activities organised in vertical ‘value’ chain
• Production activities said to flow from upstream suppliers to downstream manufacturers,distributors and retailers

Question 2

Why is organising the value chain an important part of business strategy? (Part 2)

Answer 2

• Activities in the chain include activities, which are:
  1. Associated directly with processing and distribution of inputs and outputs
  2. Professional support activities, like accounting and planning
• Understanding vertical relationships important for business strat because influence the firms composition
  e. g Business must make a buy/make choice

Question 3

What is the processes upstream and downstream?

Answer 3

1. Raw inputs
2. Transportation
3. Good processors (mills etc.)
4. Transportation
5. Assemblers
6. Transportation
7. Retailers

Also support services such as accounting etc.

Question 4

What is the make or buy decision?

Answer 4

Act of making a strategic choice between producing an item internally (in-house) or buying externally (out-house)

• Firm can produce in-house (vertical integration) or rely on market forces to provide the most efficient version of these products

Question 5

What are the differing possibilites of the make or buy decision?

Answer 5

• Not a yes or no answer and is instead a spectrum
  List goes from less integrated to more integrated:

Arm's length market transaction
Long-term contracts
Strategic Alliances and Joint Ventures
Parent/Subsidiary Relationship
In-house production

Question 6

What are the advantages of vertical separation (buy)?

Answer 6

• Lower costs, due to strong market competition
• Economies of Scales in the specialised activity
• Expertise and market incentives in vertically related markets

Question 7

What are the advantages of using the market? (PT 1)

Answer 7

• Cost savings from specialisation passed on to other phases in vertical chain (downstream) only if the market is competitive
• Specialisation limited by the size of the market. One supplier might be able to serve several buyers and rely on large market size to provide a cost advantage via economies of scale in the specialised product

Question 8

What are the advantages of using the market? (PT 2)

Answer 8

• Reduction in agency costs:
  (Slacking by employees and resulting monitoring and motivating workforce) - Higher in large companies, market firms have to reduce these costs to stay competitive

Reduction of Influence Costs:
(Time needed to influence to get resources)

Question 9

What are the advantages of Vertical Integration? (Make)

Answer 9

• Effective control over supply chain (e.g unreliable suppliers)
• When market info critical for production schedules
• When specific assets required
• In presence of concentrated upstream and downstream markets

Question 10

What are the disadvantages of using the market? (PT 1)

Answer 10

• Cost of co-ordinating activities in separate companies across vertical chain
• Contracts might be inadequate to deal with co-ordination problem when small errors can be costly (Better to co-ordinate internally)
• Unwillingness of suppliers/buyers to develop and share valuable info - Especially around IP’s or patents

Question 11

What’s meant by the co-ordination of production flows?

Answer 11

• Firms make decisions that depend in part on decisions made by other firms along vertical chain
• Without good co-ordination, bottlenecks arise in vertical chain
• To ensure co-ordination, firms rely on contracts but if contracts cannot be written or transaction costs related to them are high enough co-ordination justifies vertical integration

Question 12

What are the disadvantages of using the market? (PT 2)

Answer 12

• Limited protection via contracts
• Main costs associated with using the market are related to the costs of negotiating, writing and enforcing contracts (Transaction cost econ)
• Cost of protecting the company from potential opportunistic behaviour via complex contracts may be too high

Question 13

What are the factors that prevent complete contracting?

Answer 13

• Bounded Rationality:
• Difficulties in specifying/measuring performance
• Asymmetric Information

Question 14

What’s meant by complete contracting?

Answer 14

If the parties to an agreement could specify their respective rights and duties for every possible future state of the world, their contract would be complete.

-There would be no gaps in the terms of the contract.

Question 15

What’s meant by bounded rationality?

Answer 15

• Individuals have limited capacity to process information, deal with complexity, and pursue rational aims
• Individuals cannot foresee all possible contingencies

Question 16

What’s meant by Difficulties in specifying/measuring performance?

Answer 16

-Performance cannot always be measured unambiguously, as What constitutes fulfillment of a contract may have some residual vagueness.

Question 17

What’s meant by Asymmetric Info?

Answer 17

Parties to the contract may not have equal access to contract-relevant information, and the knowledgeable party can misrepresent information with impunity, thereby making Contracting on items that rely on this information is difficult

Question 18

What is the relation between contracts and the potential leakage of private information?

Answer 18

Firms do not want to compromise the source of their competitive advantage and private information on product design or production know-how may be compromised when outside firms are used in the vertical chain.

Question 19

How can companies prevent the leakage of Private Info?

Answer 19

• Well defined patents can help (not full protection)

- Contracts with non-compete clauses can be used to protect leakage of info, but hard to enforce

Question 20

What does using the market require?

Answer 20

Transaction costs -

Cost of negotiating, writing and enforcing contracts

Question 21

What are the sources of transaction costs?

Answer 21

• Contracting Costs and Cost of Contracting
• Investments that need to be made in relationship specific assets
• Possible opportunistic behaviour after the investment is made (holdup problem) and the potential Quasi-rents associated with holdup
  `

Question 22

What are relationship specific assets?

Answer 22

• These assets cannot be redeployed for another transaction without cost
• Once asset in place, other party to the contract cannot be replaced without cost as parties locked into relationship (can cause hold-up problem)

Question 23

What are some of the different forms of relation specific asset specificity?

Answer 23

• Site Specificity
• Physical Asset Specificity
• Dedicated Assets
• Human Assets Specificity

Question 24

What’s meant by Site Specificity?

Answer 24

• Assets may have to be located in close proximity to economise on transport costs and inventory costs
  e. g cement factories close to stone deposits

Question 25

What’s meant by Physical Asset Specificity?

Answer 25

• Physical Assets may have to be designed specifically for the particular transaction
  e. g. Molds for glass containers production custom made for particular user

Question 26

What’s meant by Dedicated Assets?

Answer 26

• Some investments made to satisfy single buyer without whom the business would not profitable
  e. g. Defence contractor’s investment into manufacturing facility for making certain advanced weapon systems

Question 27

What’s meant by Human Asset Specificity?

Answer 27

• Some of the employees of the firms engaged in the transaction may have to acquire relationship-specific skills, know-how and info
  e. g workers acquire skills to use particular entreprise resource planning software

Question 28

What is the Hold-up problem?

Answer 28

E.g once the supplier (purchaser) has invested in the asset to produce (use) an input , the purchaser can request a lower price (supplier can demand a higher price)

Essentially squeeze them by the balls

-Complete contract would not allow this

Question 29

What is the effect of the hold-up problem on transaction costs?

Answer 29

Raises the cost of transacting exchanges

• Negotiations more difficult
• Investments may have to be made to improve ex-post bargaining position
• Distrust
• Could lead to underinvestment in relationship specific assets

Question 30

What are some of the safely cost guards that can prevent the hold up problem?

Answer 30

Potential for holdup may lead parties to invest in wasteful protective measures
E.g. Manufacturer may acquire standby production facility for an input that is to be obtained from a market firm
- Vertical Integration (make) more likely with potential hold up