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24 Cards in this Set

  • Front
  • Back
value chain?
the process that begins with the acquisition of raw materials and ends with the distribution and sale of finished goods and their services
what is the main decision to make of a firm?
make or buy
vertically integrated firms are..
firms that undertake every step/activity of their activities by themselves,i.e shell
vertically disintegrated firms ...
outsource most of their activities i.e. benetton, nike
forward integration:
is the expansion of activities downstream
Client (including after-sales)

Expansion of activities downstream.
E.g., record label Virgin opening its own stores.
E.g., Magna merging with Opel instead of Fiat merging with Opel
horizontal boundaries of the firm ; main question?
what part of the market serves the firm?
backward integration ?
upstream integration:

-Suppliers of inputs

Expansion of activities upstream.
E.g., Albert Heyn buying its own slaughterhouse.
How to measure degree of vertical integration?
Added value / Sales
Porter's value chain ?
Complementary to the five forces model, Porter developed the value chain.
-Five forces model: Sector analysis
-Value chain: Firm Analysis
->Identify the competitive advantages within the value chain.
-Cost leadership
-Differentiation (e.g., better service or quality)
-Focus (best in a segment)

Make-or-buy (outsourcing) decisions within the value chain.
Outsourcing (make or buy) decision depends on:
-Scale advantages
-‘Agency’ costs and influence costs
-Incomplete contracts
-Coordination of production flows through the vertical chain
-Leakage of private information
-Transaction costs
-Idiosyncratic investments (relationship-specific investments)
-‘Holdup’ problem
Some remarks:
-In principle it does not matter which firm incurs the cost, unless there are significant scale or expertise advantages.
-We do observe a lot of outsourcing, especially to low-wage countries (off-shoring).
-Still, there is the decision to make or buy.
-However, there is also a wage (variable cost) difference.
-‘Make’ could have been the optimal solution for Wolters Kluwer in the Netherlands and the USA, but ‘buy’ in the Philippines and India.
-In line with current trend to more vertical de-integration.
Scale advanteges?
suppose the minimum efficiency scale (MES) is large for an intermediate good. Then the main producer will not produce it by himself, but he will outsource the intermediate.
Agency costs?
-Arise when employer (‘principle’) and employee (‘agent’) have different objectives.
-Agency costs will increase if firm expands.
-Higher agency costs will increase the probability of outsourcing.
Influence costs:
-In-house suppliers can use their influence with headquarters to shield against pressures to become more competitive.
-Large vertically integrated firms are more prone to influence cost problems than small independent firms.
Incomplete contracts:
+Complete contracts
-Stipulate each party’s responsibilities and rights
-Foresee all possible circumstances
-Donot allow different interpretations
-Eliminate opportunistic behavior
+Incomplete contracts
-‘Bounded rationality’
I-mpossible to foresee all possible circumstances
-Difficulties specifying or measuring performance
-Asymmetric information
Transaction costs:
-Transaction costs are all costs involved in creating and maintaining a market relation between partners
-With vertical integration, there are no transaction costs
Transaction costs include the costs of
Searching for a partner
like: Deal negotiation
Writing a contract
Enforcing a contract
Coase (1937): firms exist because they prevent transaction costs (market mechanism imperfect)

idiosyncratic investments
Coordination & private information
+Coordination of production
-Production throughout the vertical chain must be coordinated with respect to timing and product features. If a wrong fit is disastrous and not unavoidable, a firm may choose to make rather than buy.
+Leakage of private information
-Information about the content of a product may be crucial for a firm.
Firms will not be willing to share this information with others and will choose to make rather than buy.
Explanations for transaction costs:
Relation-specific (idiosyncratic) investments
Investment tied to a certain transaction that cannot be redeployed to another transaction without (productivity) loss.
Site-specific investments (e.g., aluminium plant next to bauxite mine)
Physical asset specificity and dedicated assets
Human asset specificity (e.g. courses for port management in Dutch)
Explanations for transaction costs (c’ed)
Quasi-rent and ‘hold-up’
Suppose a firm makes a profit (‘rent’) of π1 with a relation-specific investment to supply a good to another firm.
Suppose the firm can sell the good to an outside firm for π2.
Then the quasi-rent is the profit the firm makes for making the relation-specific investment: π1 - π2
If quasi-rent is high and contracts are incomplete, there is the risk of ‘hold-up’: The other firm can threaten to pay only π2 instead of π1
Explanations for transaction costs (c’ed)
Quasi-rent and ‘hold-up’
Possibility of hold-up causes an increase in transaction costs:
Complicates contract negotiations
Possibility of ‘hold-up’ causes distrust
Possibility of ‘underinvestment’
Hold-up can lead to extra costs of investment to reduce the quasi rent (make investment less specific and suitable for other firms)
E.g., Franchising (Taco-Bell, McDonalds).
How can we explain the rise in offshoring?
-ICT (information and communication technology) growth.
-Reduction in transaction costs
-Economies of scale
-Economies of scale important when fixed cost high relative to variable cost.
-Variable cost (wage cost) much lower in Asian countries.
-Institutional changes
-Asian countries have undergone significant economic liberalization.
Theory predicts a negative relation between transaction costs and market use.
-Is this in line with empirical evidence?
Joskow (1988): ‘Asset Specificity and the Structure of Vertical Relationships: Empirical Evidence’.
+Positive relationship between vertical integration and the degree of asset specificity
+In the car industry he examined which parts are outsourced and which parts are produced in-house.
If outsourcing takes place, contracts are longer if many relation-specific assets are deployed.
notes nike
Recently, a thesis student examined make-or-buy decisions at Nike.
Nike stores (owned by Nike) on a location more likely if
Number of potential clients (city size) increases.
Opening of the shop took place earlier.
Investment (legal) protection in the country is better.
Location (city center, shopping mall outside center, airport) has no impact on the decision.
Market power and double marginalization
Suppose upstream and downstream firm both have a monopoly.

Upstream supplier
charges ‘markup’ over its cost
Downstream producer
charges ‘markup’ over its cost

Price that is charged to the consumer is higher than the price an integrated firm would charge.

++Integration of upstream and downstream firm would lead to higher (aggregate) profit.
Possible alternatives to vertical integration:
Retail price maintenance (price fixing by upstream firm).
Set price of inputs equal to cost and share profit (‘franchise’).