Vertical Integration and The Scope of the Firm

1
Vertical Integration and The Scope of the Firm
OUTLINE

• Transactions Costs and the Scope of the Firm
• --Why does the firm exist?
• --The evolution of firms and markets
• The Costs and Benefits of Vertical Integration
• Designing Vertical Relationships
• Recent Trends

2
From Business Strategy to Corporate Strategy The
Scope of the Firm

• Business Strategy is concerned with how a firm
  computes within a particular market
• Corporate Strategy is concerned with where a firm
  competes, i.e. the scope of its activities
• The dimensions of scope are
• geographical scope
• vertical scope
• product scope

3
Transactions Costs and the Scope of the Firm

Vertical Product Geographical Scope Scope Scope
V1 V2 V3
A Single Integrated Firm
P3
P2
P1
C3
C2
C1
B Several Specialized Firms linked by Markets
V1
P1
P2
P3
C1
C2
C3
V2
V3
In situation A the business units are
integrated within a single firm. In situation B
the business units are independent firms linked
by markets. Are the administrative costs of the
integrated firm less than the transaction costs
of markets?
4
Transactions Costs and The Existence of the Firm

• Transaction cost theory explains not just the
  boundaries
• of firms, also the existence of firms.
• In 18th century English woollen industry, no
  firms
• independent spinners and weavers linked by
  merchants.
• Residential remodeling industry -- mainly
  independent self-
• employed builders, plumbers, electricians,
  painters.
• Key issue -- transaction costs of the market vs.
• administrative costs of firms.
• Where transaction costs highfirm is more
  efficient means
• of organization
• Note transaction costs comprise costs of search
  and contract negotiationg and enforcement

5
Aggregate Concentration in US Manufacturing,
1947-97
6
Determinants of Changes in Corporate Scope

• 1800 1980 Expanding scale and scope of
  industrial corporations due to
• declining administrative costs of firms
• Advances in transportation, information and
  communication
• technologies
• Advances in managementaccounting systems,
  decision sciences,
• financial techniques, organizational
  innovations, scientific management

1980 1995 Shrinking size and scope of biggest
industrial corporations. Increasingly
Increased no. of managerial Admin. costs
of turbulent decisions. Need for fast firms
rise relative external responses to external
to transaction environment change costs of
markets
1995 2007 Rapid increase in global
concentration (steel, aluminium, oil, beer,
banking, cement). Key drivers quest for market
power and scale economies. Also, large
corporations better at reconciling size with
agility
7
The Costs and Benefits of Vertical Integration
BENEFITS

• Technical economies from integrating processes
  e.g. iron and steel production
• but doesnt necessarily require common
  ownership
• Superior coordination
• Avoids transactions costs of market contracts in
  situations where there are
• -- small numbers of firms
• -- transaction-specific investments
• -- opportunism and strategic misrepresentation
• -- taxes and regulations on market transactions

8
The Costs and Benefits of Vertical Integration
COSTS

• Differences in optimal scale of operation between
  different stages prevents balanced VI
• Strategic differences between different vertical
  stages creates management difficulties
• Inhibits development of and exploitation of core
  competencies
• Limits flexibility -- in responding to demand
  cycles
• -- in responding to changes in
  technology,
• customer preferences, etc.
• (But, VI may be conducive to system-wide
  flexibility)
• Compounding of risk

9
When is Vertical Integration More Attractive
than Outsourcing?

• How many firms are available The fewer the
  companies
• to undertake the activities? the more
  attractive is VI
• Is transaction-specific investment If yes, VI
  more attractive
• needed?
• Does limited information permit VI can limit
  opportunism
• cheating?
• Are taxes or regulation imposed VI can avoid
  them
• on transactions?
• Do the different stages have similar Greater
  the similarity, the
• optimal scales of operation? more attractive is
  VI
• Are the two stages strategically Greater the
  strategic
• similar? similarity ---the more
  attractive is VI
• How great the need for entrepreneurship Greater
  the need, the greater
• continual upgrading of capabilities the
  disadvantages of VI
• How uncertain is market demand? Greater the
  unpredictability
• ----the more costly is VI
• Are risks compounded by VI increases risk.
• linkages between vertical stages

10
The value chain for steel cans
Canning of food, drink, oil, etc.
Iron ore mining
Steel production
Steel strip production
Can making
VERTICAL INTEGRATION, AND MARKET CONTRACTS
VERTICAL INTEGRATION
MARKET CONTRACTS
MARKET CONTRACTS
What factors explain why some stages are
vertically integrated, while others are linked by
market transactions?
11
Designing Vertical Relationships Long-Term
Contracts and Quasi-Vertical Integration

• Intermediate between spot transactions and
  vertical integration are several types of
  vertical relationships
• ---such relationships may combine benefits of
  both market transactions and internalization
• Key issues in designing vertical relationships
• -- How is risk allocated between the parties?
• -- Are the incentives appropriate?

12
Recent Trends in Vertical Relationships

• From competitive contracting to supplier
  partnerships, e.g. in autos
• From vertical integration to outsourcing (not
  just components, also IT, distribution, and
  administrative services).
• Diffusion of franchising
• Technology partnerships (e.g. IBM- Apple Canon-
  HP)
• Inter-firm networks
• General conclusion- boundaries between firms
  and markets becoming increasingly blurred.

13
Different Types of Vertical Relationship
Low
Long-term contracts
Franchises
Joint ventures
Agency agreements
Spot sales/ purchases
Low Formalization High
Supplier/ customer partnerships
Informal supplier/ customer relationships
Vertical integration
Low Degree of Commitment High