Pause For Reflection III: The Scope of the Firm

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Pause For Reflection IIIThe Scope of the Firm

• Course 15.930

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The Central Question

• Why do Firms exist? Why is everything not
  organized as one big firm?
• Much of neoclassical economics devoted to showing
  how efficient the
• Williamson/Coase suggested that firms solve
  problems in markets but contractual problems are
  ubiquitous, but it comes at an efficiency/incentiv
  e loss
• Key References
• Coase (1937)
• Williamson (1975, 1985)
• Grossman and Hart (1986)

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In practice two key distinctions

• Vertical Integration
• How much of the supply chain does it make sense
  to own?
• Diversification
• Related Diversification How many businesses
  of this type does it make sense to be in?
• Unrelated Diversification Does it make sense
  to expand the scope of the firm beyond a single
  kind of business?

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Vertical integration A way of thinking about the
issue

• Strategic (Changing the structure of
  competition)
• Raising rivals costs (Vertical foreclosure) --
  only possible if there are few upstream suppliers
• Telecommunications equipment and ATT
  diverstiture
• Avoiding double marginalization
• Cellular roaming
• Information Access
• Taxes and Regulation Avoidance
• Uncertainty of Demand--Secure Supply
• DRAMs in the late 1980s
• Competence Building
• The firm as a network of social relations, a
  repository of private languages, unique routines
  and procedures, technology and knowledge
• Incentives
• Large firms can insure individuals who might
  otherwise not undertake risky projects
• Contractual problems
• Markets underinvest in specific assets?
  Transaction cost problems make vertical
  integration a preferred solution?

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Transaction Cost Economics The Basics..and
only part of the story

• Economic Actors
• Boundedly Rational
• Opportunistic (Profit Maximizing?)
• Transactions
• Specific Investments
• Uncertainty
• Frequency
• Results
• Incomplete Contracts
• Potential for Hold-Up
• Under-Investment.
• .or no transaction at all
• Potential Solution
• Bilateral Dependency or Exchange of Hostages
• Vertical Integration

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But vertical integration is not without problems.

• Strategic and Competitive
• Bureaucratic costs
• Lack of competitive contracting environment
• Inability to direct technological future
• Competencies
• Need to consider the impact of vertical
  integration of the ability of the firm to develop
  and leverage core competencies
• Lack of focus
• Not invented here
• Incentives
• Higher-powered incentives in smaller, independent
  organizations
• Rigidities and lack of flexibility

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Concepts in practice (1) Vertical integration

• Ikea Why does Ikea own its own stores?
• Intel Should Intel enter the PC business?
• Body Shop Why does the Body Shop manufacture
  most of its own products?
• Birds Eye Why didnt Birds Eye buy the freezer
  cabinets that it had to persuade retailers to
  install?
• Honda Why didnt Honda set up a franchising
  operation like Body Shop or a wholly owned
  distribution channel like Ikea when it entered
  the US?

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Diversification Key ideas

• Economies of scope and synergies
• C(A) C(B) C(AB)
• Exploiting core competencies
• How do we define relatedness? Products or
  competencies?
• PH 3 criteria
• How would we measure relatedness? SIC codes,
  patents
• Market power
• Multi-market contact may make collusion easier?
• Informed market when external markets are weak
• Profit stability
• Lowers the risk of bankruptcy, reduces managerial
  risk and increases the probability that high
  quality managers will commit to the firm
• Potential agency issues

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Diversification A complementary perspective

• Strategic (Changing the structure of competition
  and cost)
• Multi-market competition may reduce rivalry, make
  collusion easier
• Economies of scope, scale and synergies
• Competence Building
• The firm as a network of social relations, a
  repository of private languages, unique routines
  and procedures allows exploitation of core
  competence
• Incentives
• Diversified firms can insure individuals who
  might otherwise not undertake risky projects,
  and can retain highly talented individuals who
  might not otherwise invest in dull or slow
  growth businesses
• Contractual Problems
• Diversified firms can act as a market for labor
  or capital WHEN there is market failure or lack
  of information
• Transaction costs

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Diversification Problems and Performance Issues

• Agency Problems What are the motivations of
  managers?
• Shareholder Diversification of Risk
• Winners Curse
• Fashion and Fads
• Lack of flexibility
• Diseconomies of Scale and Scope
• Bureaucracy
• Spreading Resources too Thin
• Performance Results?
• Studies are very difficult to do, but stylized
  fact is that related diversifiers perform better
  than unrelated diversifiers
• Why did General Electric (GE) survive when
  Beatrice didnt?

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Concepts in Practice (2)Diversification

• Intel Should Intel enter the software business?
• Body Shop Should the Body Shop diversify? If so,
  what into?
• American Express Was the financial supermarket
  strategy misconceived or simply badly executed?
• Crown Equipment Should Crown diversify? If so,
  what into?
• Benetton Was diversification at Benetton always
  doomed? Why or why not?

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What is the role of top management?

• Establish corporate wide strategic architecture
  which
• develops organization-wide competencies
• Is it more difficult to build competencies
  through internal investment or MA?
• protects against contracting hazards
• maximizes incentives while protecting investments
  
• takes into account competition and strategic
  factors
• Mergers acquisitions and divestitures should be
  thought of in this context, not as pieces of the
  chessboard
• Avoid fads and fashion
• Focus on the fundamentals