Lecture 2 - Boundaries of the Firm

Question 1

Explain transaction costs theory.

Answer 1

• The transaction cost theory supposes that companies try to minimize the costs of exchanging resources with the environment, and that companies try to minimize the bureaucratic costs of exchanges within the company.
• Companies are therefore weighing the costs of exchanging resources with the environment, against the bureaucratic costs of performing activities in-house.

Question 2

Activities are undertaken by the firm or market depending on what relative costs?

Answer 2

• Transaction costs - Search costs, contract negotiation and monitoring etc.
• Administrative costs - Management coordination, employments contracts etc.

If transcation costs > administrative costs then coordination of productive activities will be internalised within firms.

Question 3

What are the two forms of economic organisation that capitalist economy comprises of?

Answer 3

• Market mechanism - Prices determine the production and resource allocation.
• Administrative mechanism - Production and resource allocation made by managers and imposed through hierarchies.

Question 4

What is vertical integration?

Answer 4

• Vertical integration is a strategy where a company expands its business operations into different steps on the same production path, such as when a manufacturer owns its supplier and/or distributor.
• Vertical integration can help companies reduce costs and improve efficiencies by decreasing transportation expenses and reducing turnaroundtime, among other advantages.
• However, sometimes it is more effective for a company to rely on the established expertise and economies of scale of other vendors rather than trying to become vertically integrated.

Question 5

What is horizontal scope/integration?

Answer 5

• Horizontal integration is the acquisition of additional business activities that are at the same level of the value chain in similar or different industries.
• This can be achieved by internal expansion through a reinvestment of operating profits or by external expansion through a merger or acquisition (M&A).
• Since the different firms integrating are involved in the same stage of production, horizontal integration allows them to share resources at that level.

Question 6

Illustrate the differences of:

[A] single integrated firm

[B] Several Specialised Firms linked by Markets

(in both a vertical scope and horizontal scope)

Answer 6

• Situation [A] businesses 1, 2 & 3 are integrated within a single firm.
• Situation [B] businesses 1, 2 & 3 are independent firms linked by markets.

Question 7

Explain how economies of scale/diseconomies of scale with in terms of average cost.

Answer 7

Question 8

What are the effects of economies of scale?

Answer 8

• create cost advantages
• determine market structure and entry/exit - makes it hard for new entrants to join market since existing firms products at low cost.
• affect the internal organisation of firms
• determine the vertical and horizontal boundaries of firms.

Question 9

What does the U-shaped AC curve say about the optimum size for a firm?

Answer 9

• Average cost decilnes as fixed costs are spread over larger volumes.
• Average cost eventually starts increasing as capacity constraints kick in.
• U-shape implies cost disadvantage for very small and very large firms.
• Optimum size for a firm inbetween extremes.

Question 10

Explain the L-Shaped cost curve and what the MES is.

Answer 10

• In reality, cost curves are closer to being L-shaped than U-shaped.
• Large firms are rarely at a cost disadvantage relative to smaller firms.
• A minimum efficient size (MES) beyond which average costs are identical across firms.

Question 11

Describe sources of economies of scale

Answer 11

• Spreading of fixed costs
  
  • R&D
  • Specialised equipment or building/stores
  • Training and HR
  • Marketing (Advertising and Brands)
  • Purchasing and distribution costs
  • IT costs
• Digitalisation
  
  • Use of digital technologies to provide new means of value creation and improve processes/business models
  • production and distribution which are separate activities (e.g., for books and music) could be coupled into a single business model when transformed into a digital format
  • saving on inventories (e.g., Amazon vs Borders, Apple iTunes vs HMV Records)

Question 12

What are sources of diseconomies?

Answer 12

• Increasing labour costs
• Spreading specialised resources to thinly - e.g. having someone specialised in a task doing more work over a range of things - takes away from what hes good at/efficiency.
• Incentive and coordination effects
• “Conflicting out” - (competitor already a client; informal sensitivity, reputation damage)

Question 13

Explain why larger firms might exit an industry first.

Answer 13

• Larger firms will experience loss in profits more if demand goes down because their costs are higher. Hence will be first to exit industry.
• High fixed cost - Larger factory, larger plant etc.

Question 14

Explain the maths in economies of scope.

Answer 14

• It is cheaper for one firm to produce both X and Y than for two different firms to specialise in X and T each.

Question 15

What are some sources of economies of scope?

Answer 15

• Scope economies might arise from:
  
  • Sharing tangible resources (research labs, distribution systems) across multiple businesses.
  • Sharing intangible resources (brands, technology) across multiple businesses
  • Transferring functional capabilities (marketing, product development) across businesses.
  • Applying common general management capabilities to different businesses.
• Cross sales and complementarity.

Question 16

Explain learning economies with the learning curve.

Answer 16

• Learning economies depend on cumulative output rather than the rate of output - reduces unit costs through experience.
• Learning leads to lower costs, higher quality and more effective pricing and marketing.
• Learning economies are distinct from economies of scale:
  
  • Capital intensive technologies can offer scale economies even if there is no learning
  • Complex labour intensive processes may offer learning economies without scale economies.

Question 17

Describe the Hub and Spoke model and explain how it drives both scale and scope economies in the airline business.

Answer 17

• The small number of routes may also lead to more efficient use of transportation resources. For a same number of aircraft, having less routes to fly means each route can be flown more frequently and with higher capacity because the demand for passengers can be resourced from more than just one city.
• Complicated operations, such as package sorting and accounting, can be carried out at the hub rather than at every node, and this leads to economies of scale. As a result of this, spokes are simpler to operate and so new routes can easily be created.
• Downfalls:
  
  • because the model is centralised, day-to-day operations may be relatively inflexible, and changes at the hub, even in a single route, may have unexpected consequences throughout the network

Question 18

Explain the low cost airline business model and how it drives scale and scope.

Answer 18

• Only flies into regional airports, no landing fees
• Guarantees airport certain number of passengers in their terminal
• Airport provides low cost airlines (LCA) a percentage of the revenues from customer facilities.

Question 19

What is the vertical chain?

What are meant by the vertical boundaries of a firm?

Answer 19

• The vertical chain
  
  • beings with the acquisition of raw materials (upstream)
  • ends with the sale of finished goods/services (downstream)
• Vertical boundaries of the firm determine which tasks are to be performed inside the firm and which to be out-sourced.
• Outside specialists who can perform vertical chain tasks are market firms, market firms might be recognised leaders in their field.
• The choice between using the market or using the organisation is a make or buy decision.

Question 20

In the vertical chain, what are reasons to buy(from market firms)?

Answer 20

• Market firms may have patents or proprietary information that makes low cost production possible
• Market firms can achieve economies of scale that in-house units cannot
• Market firms are likely to exploit learning economies.

Question 21

In vertical chians, what are reasons to make?

Answer 21

• Ensuring steady supply of raw materials
  
  • if the source of raw materials is illiquid and inefficient
  • if traded freely on commodity makets then no benefit from making.
  • an arms-length transaction is simple internalised within the firm if transfer prices are set at the market rate - constant transfer price will lead to inefficient use of raw materials.
• High transactions costs
  
  • Agency costs and the metering problem
  • Relationship specific assests and holdup problem
  • Inability to contract due to incomplete contracts

Question 22

Explain what are agency costs and the metering problem.

Answer 22

• The production of a complex output may require contributions from several input-owners.
• When there joint costs measuring and rewarding individual unit’s performance is difficult.
• Where only the overall output is measurable there will be a tendency for input-owners to free-ride or shirk/slack, to the detriment of all.
• Therefore, it might be better to irganise within the same firm with hierarchical montiroring rather than transfer within a market environment - all work can be monitored in house.

Question 23

What are relationship-specific assets?

Answer 23

• Relation-specific assets are assets essential for a given transaction, there assets cannot be redeployed for another transaction without cost.
• Relation-specific assets may exhibit different forms of specificity:
  
  • Site specificity (Cement factories are located near lime stone deposits)
  • Physical asset specificity (Molds for glass container production custom made for a particular user)
  • Dedicated assets ( A defense contractor’s investment in manufacturing facility for making certain advanced weapon systems.)
  • Human asset specificity ( Salespersons posses detailed knowledge of customer firm’s internal organisation)

Question 24

Explain the hold-up problem in relation to relationship-specific assets.

Answer 24

• Relation-specific assets support a particular transaction so its costly to change its use.
• Possible opportunistic behaviour after the investment is made (hold-up problem)
• Quasi rents (economic profit in excess on the minimum needed to deploy the relationship specific asset) become available to one party and there is incentive for a hold-up - rent seeking theory.
• Potential for hold-ups lead to:
  
  • Underinvestment in these assets
  • Investment in safeguards
  • Reduced trust

Question 25

What are the role of contracts between firms?

Answer 25

* Firms often use contracts when certain tasks are performed outside the firm. * **Contracts list:** * the set of tasks that need to be performed * the remedies if one party fails to fulfill its obligation and, * the cost to perform the task * Contracts protect each party to a transation from the opportunistic behaviour of the other party. * Contracts provide this protection by * the "completeness" of the contract * the body of contract law

Question 26

What are reasons that contracts are never fully complete?

Answer 26

* Contracts do not anticipate all possible contingencies * They do not spell out rights and responsibilities of parties completely * **Factors that prevent complete contracting:** * Bounded rationality: limited capacity to process information. * Diffculties in specifying/measuring performance unambiguously * Asymmetric information: parties might not have equal access to contract-relevant information.

Question 27

What is technical and agency efficiency? What are the benefits of vertical integration?

Answer 27

* Using the market improves technical efficiency (least cost production) * Vertical integration improves agency efficiency (coordination, transactions costs) * Firms should "economise" - choose the best possible combination of technical and agency efficiencies. * **Benefits from vertical integration:** * Avoids transaction costs of market contracts (e.g., opportunism and strategic misrepresenation, design specificity costs, avoids taxes and other costs) * Superior coordination

Question 28

Give examples of using the market and examples of vertical integration.

Answer 28

* Fast turn-around from superior coordination - Zara manufactures its own clothes compared to the traditional model of outsourcing the manufacturing process. * Specialised investment - Private banking have their customer relationship advisors for high-net worth clients but use third party financial advisors for affluent customers. * Greater design specificity - Reva electric cars in India become one of the largest plastics manufacturer.

Question 29

What are the costs (issues) of vertical integration?

Answer 29

* Differences in optimal scale of operation between different stages of production: prevents balanced vertical integration * Inhibits development of distinctive capabilities. * Difficulties of managing strategically different businesses * Incentive problems: lack of "high-powered" incentives * Compounding of risk (problem in one stage affects the other stages) * **Limits flexibility:** * In responding to demand fluctuations * In responding to changes in technology, customer preferences, etc.

Question 30

Describe the different intermediate types of vertical relationships?

Answer 30

* From competitive contraction to supplier partnerships, e.g., in autos * From vertical integration to outsourcing (not just components, also IT, distribution, and administrative services) * Diffusion of franchising (capital sum plus royalty payments to create aligned incentives) * Technology partnerships (e.g., IBM - Apple IBM MobileFirst Platform for IOS; Canon-HP) * Inter-firm networks.

Question 31

What are motivations for firm diversification?

Answer 31

* **Growth** * The desire to escape stagnant or declining industries a powerful motives for diversification (e.g., tobacco, oil, newspapers) * But, growth satisfies managers not shareholders - such diversification seeks growth (esp. by acquisition) but tends to destroy shareholder value. * **Risk Spreading** * Diversification reduces the variance of profit flows * But, doesn't create value for shareholders - they can hold diversified portfolios of securities * **Value Creation** * For diversification to create shareholder value, then putting different businesses under common ownership must increase their total profitability.

Question 32

If diversification is to create shareholder value, what three test must it meet?

Answer 32

* **The attractiveness test** * Diversification must be directed towards attracted industries (or have the potential to become attractive) - are you going to industries that are growing? * **The Cost of Entry Test** * The cost of entry must not capitilise all future profits * **The Better-Off Test** * Either the new unit must gain competitive advantage from its link with the company, or vice versa (i.e., some form of "synergy" must be present)

Question 33

What are the competitive advantages from diversification?

Answer 33

* **_Economies of scope_** * **Operational readiness** * Synergies from sharing resources across businesses (common distribution facilities, brands, joint R&D) * **Strategic readiness** * Synergies at the corporate level deriving from the abilitiy to apply common management capabilities to different businesses. * **Economies from internalising transactions** * Diversified firm can avoid external transactions by operating internal capital and labour markets * Diversified firm has better information on resource characteristics than external markets

Question 34

Draw BCG's growth/Share matrix.

Answer 34

* Use the cash generated by "cash cows" to exploit the learning economies of "rising stars" and "problem children". * Dog - want to get rid of it but still have it.

Question 35

Do diversefied firms outperform specialised firms?

Answer 35

* No consistent relationship * Some evidence of a curvilinear relationship: first diversified increases profitability, but beyond a point further reduces profitability (increased complexity?) - moderate diversification. * Question of direction of causation: does diversification drive profitability, or vice-versa?

Question 36

What type of diversification is most profitable? Related diversification vs. unrelated diversification.

Answer 36

* Most studies (but not all) show related diversification outperforms unrealated diversification * related diversification offers greater synergies - but imposes higher mangement costs * But what is "related diversification"? Businesses can be related in many different ways (e.g. GE with Financial Services, Virgin Group)

Question 37

What are sources of strategic relatedness between business?

Answer 37

Question 38

What is the layered modular architecture in the digital economy?

Answer 38