The Vertical Boundaries Of The Firm


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The Vertical Boundaries Of The Firm

  1. 1. The Vertical Boundaries of the Firm (Organization of Economic Activity ) Chapter 3
  2. 2. <ul><li>Raw Inputs </li></ul><ul><li>(trees, Iron, cows etc.) </li></ul><ul><li>Transportation </li></ul><ul><li>Intermediate Goods Processing </li></ul><ul><li>(lumber milling, frame fabrication) </li></ul><ul><li>Transportation and Warehousing </li></ul><ul><li>Assemblers </li></ul><ul><li>(furniture manufacture) </li></ul><ul><li>Transportation and Warehousing </li></ul><ul><li>Retailers </li></ul><ul><li>(furniture stores) </li></ul>The Vertical Chain of Production for Furniture Processing and Handling Accounting Finance Human Resource Management Legal Support Marketing Planning Other Support Services Support Services
  3. 3. In-Bound Logistics Manufacturing Operations Outbound Logistics Marketing and Sales Customer Service The Value Chain Procurement Technology Development Human Resource Management Infrastructure Activities Primary Activities Support Activities Value-added Value-added Value-added Value-added
  4. 4. The Make versus Buy Decision Upstream-Downstream More Integrated Less Integrated Perform Activity Internally Parent/Subsidiary Relationships Strategic Alliances and Joint Venture Long-Term Contracts Arm’s Length Transaction Make or Buy Continuum
  5. 5. Benefits of Using the Market Efficiencies resulting from competitive market dynamics Market firms can achieve economies of scale Use of specialized or proprietary technologies MES versus organizational requirements Intangible benefits Avoidance of agency and influence costs
  6. 6. Costs of Using the Market Poor coordination in the value chain Reluctance of trading partners to share valuable information Transaction Costs
  7. 7. Coordination of Production Flows Through the Vertical Chain Coordination is especially important when design attributes are present Design attributes are attributes that need to relate to each other in a precise fashion Timing fit Size fit R&D fit
  8. 8. Leakage of Private information Private information can be a major source of competitive advantage   Use of the market can increase the risk of losing control of proprietary information
  9. 9. The Economic Foundations of Contracts Complete versus Incomplete Contracts Factors that prevent complete contracting Bounded rationality Difficulties in specifying performance Asymmetric Information Role of Contract Law – Uniform Commercial Code
  10. 10. Transaction Costs Inability to write enforceable contracts that cover all contingencies and penalize shirking Transaction: An autonomous exchange of goods or services between parties with no formal agreement that the relationship will continue into the future Transactions Costs : the costs arising from organizing and transacting exchanges Key Characteristics of Transaction Costs Strong mutual reliance by each party after agreement has been reached Efforts by one or more parties to “sweeten” its end of the deal
  11. 11. Relationship-Specific Assets RSA lock parties into a relationship to a certain degree Relationship-specific assets (RSA) : an investment made to support a given transaction Cannot be redeployed to another transaction without some loss in productivity or adjustment cost
  12. 12. Forms of Asset Fixity Site Specificity Physical Asset Specificity Dedicated Assets Human Asset Specificity
  13. 13. Rents and Quasi-Rents Rents and Quasi-Rents are associated with opportunity cost before (ex ante ) and after ( ex post ) the fundamental transformation Rent: the difference between the revenue the firm receives and that which it must receive to enter into a given relationship Quasi-Rent : the difference between (a) the revenue the seller would actually receive if the deal were completed according to the original terms of a contract; and (b) the revenue it must receive to be induced to not exit the relationship after a relationship-specific investment has been made
  14. 14. Rent = pQ-TVC-I   Quasi-Rent = pQ-TVC-S where: p = price Q = quantity produced TVC = total variable cost I = ex ante opportunity cost of investment S = ex post opportunity cost of investment Rents and Quasi-Rents
  15. 15. Example: Rents and Quasi-Rents $3,000,000/year   $2,000,000/year   $5,000,000/year     $5,000,000/year   $0/year   $500,000/year   $3,500,000/year   $1,500,000/year (1)   Total variable cost   (2) Ex ante opportunity cost   (3) Minimum revenue required to enter the relationship (1)+(2)   (4) Actual revenue   (5) Sellers rent   (6) Ex post opportunity cost   (7) Minimum revenue require to prevent exit (1)+(6)   (8) Quasi-rent (4)-(7)
  16. 16. The Holdup Problem The holdup problem arises when a party to a contractual relationship exploits the other party’s vulnerability due to a relationship-specific asset. Manifest in the redistribution of quasi rents through: contractual negotiation unilateral actions by one party at the expense of another  
  17. 17. The Holdup Problem and Transactions costs The holdup problem increases transaction costs in four ways : Increased difficulty in contract negotiations and more frequent renegotiations Investment to improve ex post bargaining positions Distrust Reduced investment in relationship-specific investments
  18. 18. Issue Tree Are there existing suppliers that can attain economies of scale that an in-house unit Cannot? Do they possess execution capabilities that an in house unit would not? Would “intermediate” arrangements (alliances etc.) suffice? Are there significant relationship -specific assets? are there significant coordination problems involved in leakage of private information? Is detailed contracting infeasible or too costly? Is common ownership needed to mitigate contracting problems? Use the market Vertical integration Alliances, joint ventures Or other close-knit non-ownership arrangements Vertical integration No No No No No No Yes Yes Yes Yes Yes