Ch 06

Front 1

Make-or-buy decision depends on:

Back 1

+Technical efficiency
-Production method with lowest cost
-Using the market (outsourcing) improves technical efficiency.
+‘Agency’ efficiency
-Production method with lowest agency, influence and transaction cost.
-Vertical integration improves agency efficiency due to lower transaction costs.

Front 2

Technical efficiency

Back 2

Difference in production cost between vertical integration and outsourcing (ΔT) depends on the specificity of assets.
When assets become more specific, using the market will be less advantageous (fewer suppliers, scale advantages of suppliers not exploited).
E.g. car tires vis-à-vis car model.

Front 3

Agency efficiency

Back 3

Difference in transaction costs between vertical integration and outsourcing (ΔA) also depends on the specificity of assets.
When assets become more specific, outsourcing leads to higher transaction costs.

Front 4

What if the scale of transaction increases?

Back 4

+Vertically integrated firm can better exploit scale advantages.
-Difference in technical efficiency between vertical integration and outsourcing decreases: ΔT curve shifts downward.
+Magnifies transaction cost, agency cost and influence cost.
-Therefore, ΔA curve rotates clockwise.
+Joint effect on cost can be graphically displayed (next slide):

k***<k** :
Larger scale of transaction leads to more vertical integration.

Front 5

Conclusions of the trade-off:

Back 5

+‘standard’ inputs outsourced
Car components have become less specific, so more outsourcing (and now all cars look like each other…)
+Specialized components produced in-house.
+If a firm serves a larger size of the market, it is more likely to be vertically integrated.
In the market for sports cars, Ferrari is more vertically integrated than Spyker. E.g., engine for Spyker C8 is supplied by Audi.

Front 6

some facts

Back 6

Make-or-buy decision is essentially a decision regarding ownership and control rights about assets (Grossman, Hart and Moore)
Ownership brings with it the residual control rights
Residual rights (rights that are not explicitly stipulated in a contract) are for the owner.
Important for e.g. pharmaceutical firms.
With complete contracts it does not matter who owns the assets in the vertical chain.
With incomplete contracts, ownership determines the willingness of each part to make relationship-specific investments.

Front 7

(Backward/forward) integration affects the incentives to invest in relationship-specific assets
Whether vertical integration is optimal or not depends on the relative contribution to value added by each party’s investment

Back 7

If the investments by the upstream player and the downstream player are of comparable importance, market exchange is preferred
If the investment by one player is more important in value creation, vertical integration is preferred and this player will be allocated ownership.

Front 8

Explanation:

Back 8

Suppose that downstream firm’s investment increases her payoff also if trade does not occur
So, if downstream firm owns the asset, she can realize positive payoff.
Suppose that upstream firm’s investment is idiosyncratic
So, if upstream firm owns the asset, his default payoff is zero.
Upstream investment is relatively more important.
If upstream firm owns the asset, no risk of holdup.
Hence, asset ownership by upstream firm is optimal (forward integration).

Front 9

Governance in Integrated Firms?

Back 9

+Contracts determine decision rights between firms.
+Governance determines decision rights within an (integrated) firm.
-It’s not clear what happens to governance when two firms merge.
-Theory of Grossman, Hart and Moore can be applied to divisions within a firm
--Decision making rights (‘ownership’) should be given to division whose decisions have greatest impact on performance of activity.

Front 10

Alternatives to vertical integration?

Back 10

+A firm can integrate backward or forward through ‘greenfield’ investments, merger or acquisition.
+Alternatives to vertical integration are:
-Tapered integration (make-and-buy)
-Joint ventures and strategic alliances
->Of growing importance in the network economy.
-Implicit contracts and collaborative relationships (e.g. the Japanese Keiretsu)

Front 11

Make and buy (‘tapered integration’)?

Back 11

+Firm produces part of the inputs and outsources the rest.
Common in R&D (buying licenses and own R&D)
Coca-Cola produces cola in-house and sells licenses to independent firms.
+Or, firm sells part of its products through own retail channels and the rest through independent retailers.
Shell
Microsoft
Virgin

Front 12

Advantages of tapered integration?

Back 12

+Smaller investments
+Reduces asymmetric information about cost (which is useful in contract negotiations).
+‘Make’ signals to other firm that firm can produce itself.
+At the same time ‘buy’ can have a disciplinary effect on own firm.
+Protection against uncertainty in demand (the certain demand part can be made and the uncertain demand part can be bought).

Front 13

Disadvantages of tapered integration?

Back 13

-Splitting production can increase average cost of there are economies of scale
-Possible coordination and monitoring problems (product specifications, quality, delivery etc.)
-Internal production cost as benchmark for external production cost can be misleading if internal production is inefficient.

Front 14

Joint venture?

Back 14

-A firm that is jointly owned by two or more parent firms for research, production, marketing, etc.
E.g., Sony Ericsson is JV between Sony and Ericsson for mobile phones.
-Sometimes firms can only enter a market through a joint venture (e.g., China in some sectors).
-JVs often result in an acquisition.
-Advantages: scale advantages, exchange of knowledge, risk reduction.
-Disadvantages: cooperation between different cultures appears difficult, distrust and free-rider problem.

Front 15

Strategic Alliances?

Back 15

+Explicit cooperation between 2 or more firms.
+Firms remain independent.
+Can takes different forms, e.g.
-License agreements
-Franchising
-Purchasing pool
-Quality label (e.g., ‘Max Havelaar’)
-System integration (e.g. booking systems for hotels)
-Cooperation in research and development (Philips’ Senseo)
+Advantages and disadvantages more or less similar to JV

Front 16

Instead of contracting, JVs and SAs are primarily based on trust.!

Back 16

Ford lost its dominant position when it started to outsource certain activities. Toyota, on the contrary, gained significant market share by the creation of SAs.

Front 17

facts: Especially in Japan firms are less vertically integrated than in Europe or USA.

Back 17

Japanese firm organize production with long-run collaborative relationships with other firms.
Subcontracting networks
Suppliers make more relationship specific investments as compared to suppliers in Europe and USA.
E.g., Toyota
Keiretsu
Set of companies with interlocking business relationships and shareholdings.
Companies from different sectors (manufacturing, bank, other services)
E.g., Mitsubishi, Fuyo

Front 18

Collaborative Relationships and Implicit Contracts?

Back 18

Keiretsu is an example of an implicit contract.
Firms exchange equity shares and place individuals on each other’s board of directors.
Firms act cooperatively.
Implicit contracts not enforceable in court.
Threat of losing future business if one party breaks implicit contract.
All parties gain by cooperating.
Reputation loss has serious consequences.
Agency costs and keiretsu?
Influence costs and keiretsu?