Vertical scope of the Firm Session 5 UofC

Vertical Scope of the Firm
Session 5

Vertical Integration
• Question:
– Which activities in the vertical chain should the firm perform?
– “Make-or-buy” decision
• Vertical integration:
– A single firm decides to perform multiple activities along the
vertical chain
– Forward integration and backward integration
• Forward integration: a firm performs activities typically done
by its customers (downstream firms)
• Backward integration: a firm performs activities typically done
by its suppliers (upstream firms)

Costs of Vertical Integration
(Benefits of Using the Market)
• Economies of Scale and Scope:
• Supplier/buyer firms can achieve more economies of scale in
production:
– In-house department produces less than market specialist
– Even the largest industrial companies benefit from buying air
transportation services rather than supplying the services
themselves
• Supplier/buyer firms can achieve more economies of scope in
production by engaging in activities that are unrelated with the
buying/supplying firm’s business

• Market provides higher-powered incentives for managers:
– Divisions within firms do not face same incentives as market firms
• Agency costs
– Harder to control slack within divisions
– Agency costs are costs of slack and cost of actions aimed
at preventing/moderating slack
• Influence costs
– Misdirected efforts within divisions as division managers
seek to attain greater resources+cost of subsequent
misallocation of resources
– E.g. pressures to maintain an inefficient unit
– Example: Non-oil segments in oil and gas companies

• Market allows for competitive bidding across all possible
suppliers/buyers
• Market reduces potential competition with suppliers and buyers
– Suppliers and buyers may be less willing to interact with firms
when firm is also competing with them in other markets

Benefits of Vertical Integration
(Costs of Using the Market)
• Main Rationales for Vertical Integration:
– Better exploiting or creating market power
– Raising rivals’ costs
– Correcting market failures due to externalities
– Lowering transaction costs

Benefit of Vertical Integration:
Better Exploiting or Creating Market Power
• Successive monopoly problem/Double marginalization problem:
– If manufacturer and distributor both have market power, they each
add their own markup to price
– Consumers face two markups instead of one
– Sum of profits of manufacturer and distributor lower than what can
be achieved if only one firm
– Integration enables efficient pricing

• A Numerical example of the double marginalization problem:
• Upstream and downstream firms are monopolists
• Demand curve for final product: P=10-Q/16
• Upstream firm cost: MC=AC=$1/unit
• Upstream firm charges a price of T
• Downstream firm cost: MC=AC=$(T+2)/unit
• If integration:
– MR(=10-Q/8)=MC(=3)
– Q=56, P=6.50
– Profit=56*(6.50-3)=196
• If no integration:
– Downstream firm: MR(=10-Q/8)=MC=(2+T)
– Q=8(8-T)
– Upstream firm: MR(=8-Q/4)=MC=1
– Q=28, P=8.25
– Total Profit=28*(8.25-3)=147

• There are alternatives to vertical integration in this case
• Vertical Restrictions:
– Manufacturer imposes a maximum retail price to distributor
– Manufacturer imposes a sales quota (minimum number of units)
• E.g. automobile dealerships, computer retailers
– Manufacturer imposes a two-part pricing scheme
• One price for the product, another price for right to sell the
product
• These vertical restraints economize on previously discussed costs
of integration

• Monopoly supplier of an input may vertically integrate so that it
can successfully price-discriminate:
– Ability to prevent resale central to success of price discrimination
strategies
– Vertical integration may help prevent resale
– Example:
• Aluminum ingot used to produce electric cable and aircraft
• Good substitutes for aluminum in cables (copper); no good substitutes
in aircraft
• Profitable to charge higher prices to aircraft manufacturers
• Fear of resale provides rational for aluminum producer to forward
integrate into aluminum wire production
• E.g. Alcoa’s pattern of vertical integration into cookware, electric
cable and auto parts when it was a monopoly supplier of aluminum in
early 1900s.

Raising Rivals’ Costs
• Vertical Foreclosure = Exclusion that results when a downstream
buyer is denied access to an upstream supplier (Upstream
Foreclosure) or when an upstream supplier is denied access to a
downstream buyer (Downstream Foreclosure)
• Example:
– Barnes and Noble, Inc.’s proposed merger with Ingram Book
Group in late 1990s
• Eventually abandoned after FTC report
– Ingram by far largest book wholesaler in U.S.
– Fear that, after the merger, Barnes and Noble would have power to
foreclose retail competitors from access to important upstream
supplier
• Could raise costs of independent bookstores/internet retailers
– Note: Need entry barriers in upstream markets

Correcting Market Failures Due to Externalities
• Example: Reputation externalities
– Value in maintaining high uniform standards
– E.g. Tandy has an incentive to integrate forward into
distribution/own Radio Shack stores

Lowering Transaction Costs
• In theory, exchanges/incentives that take place within a firm could
be replicated across firms through optimal arm length’s contracts
– See discussion above of vertical restraints as an alternative to vertical
integration to deal with double marginalization problem
– Or consider exclusive dealing as an alternative to vertical integration to
achieve vertical foreclosure
• Optimal contracts do not need to be renegotiated
• However, writing such optimal contracts is costly
– Difficult to think ahead, describe all possible contingencies and actions to
be taken in each case

• Example: GM and Fischer-Body
• In stable environment, “easy” to write contract about quantity,
price and quality of car bodies Fischer should supply to GM
– E.g. 2000 bodies a day, of a specified type, for the foreseeable
future
• But what if changes in the environment?
– Shock to demand for GM, shock to cost to Fischer-Body, new
regulations on car pollution, new trade agreement with Japan,
innovation in car and body production, etc…

• In practice, complex exchanges generate transaction costs because
of incomplete contracts
– Inability to specify all outcomes, verify actions create potential for
opportunistic behavior when contracts have to be revised/renegogiated.
– Each side may try to interpret the terms of a contract to its advantage,
especially when terms are vague or even missing
• Transaction costs are costs associated with trying to write better
contracts, costs of disputing contracts, costs of renegotiating.
• Opportunities for exploitation are greater when one firm is wholly
dependent on another
– Otherwise can switch to new trading partners at the renegogiation stage

• Transactions that involve any of the following are likely to be
characterized by high transaction costs, making vertical
integration more desirable:
– Specialized assets
• A specialized asset is tailor-made for one or a few specific buyers
• Specific physical capital, specific human capital, site-specific capital
• Resulting lock-in leads to possible hold-up problems (see next slides)
– Uncertainty
• for example, uncertainty about the quality of a durable machine
– Incomplete information
• for example, supplying firm must develop important information on
newly developing markets
– Extensive need for coordination
• for example, production timing, terms of input specification
• Example: coordination needed between Pepsi-cola and its bottlers to
organize more and more sophisticated retailing/marketing activities

• A simple example of a hold-up problem:
• MIKE is looking for a market firm to manufacture its sneakers
• TOTSHOP, a small manufacturer in Asia is considering being a supplier for
MIKE
• It would cost $100 million to build a factory to manufacture MIKE shores
– Factory will have capacity to produce 5 million pairs per year
– Financing plan requires annual interest charge of $15 million for plant and
equipment
– Production cost to manufacture sneakers is $11 million per year
(avoidable if no production)
• MIKE has a contract on the table promising TOTSHOP $30 million per year

• A simple example of a hold-up problem (continued):
• Annual Profit for TOTSHOP: $30 - $15 - $11=$4 million per year
• BUT the factory would be highly SPECIFIC to the production of MIKE
sneakers.
– Tooled up for MIKE’s patented designs
• If TOTSHOP does not produce for MIKE, cannot use for other brands
• TOTSHOP’s next best alternative (if does not produce for MIKE):
– Day care in the factory, leading to $1 million per year in revenue (this is
the ex-post opportunity cost)
• Imagine TOTSHOP makes the investment in the factory
• One year later, MIKE insists for renegotiating contract. Take-it-or-leave-it
offer:
– “Will pay you $12.5 million per year for the 5 million pairs of shoes”
• Question: What should TOTSHOP do?

• A simple example of a hold-up problem (continued):
• Answer: TOTSHOP should take the offer!
– If accepts: $12.5-$15-$11= $-13.5 million per year
– If rejects: $1-$15=$-14 million per year
• Because the investment is highly relation specific, MIKE can exploit
TOTSHOP
• The next best alternative for TOTSHOP on this highly relation-specific
investment yields a much smaller revenue stream

• The hold-up problem raises transaction costs:
– More difficult contract negotiations and renegotiations
– Wasteful investments in improving ex-post bargaining position
– Distrust
– Reduced investment in relationship-specific investments
• Integration alleviates problems raised by transaction costs
• Examples:
– Make-or-buy in the aerospace industry
• High design specificity inputs more likely to be produced in-house
– Backward integration by electric utilities into coal-mining

• In the presence of incomplete contracts, ownership matters
• Patterns of ownership affect willingness to invest in relationship-
specific assets
• Ownership gives stronger bargaining position/lowers threat of
expropriation
– Residual control rights:
– Rights to decide of usage of asset in all circumstances where contract, law
or custom are silent
• Firm whose investment in relationship-specific asset have the
biggest impact on value creation should get ownership
• If both firms do equivalently important investment in relationship-
specific assets, non-integration may be optimal

Conclusion:
Make-or-Buy/Integration Fallacies
• A few commonly used justifications for increasing or not
increasing the scope of the firm that do not make (much) economic
sense:
– Fallacy 1: Firms should generally use the market to avoid the costs
of making the product
– Fallacy 2: Vertical integration is better because we can obtain the
activity “at cost” and avoid paying a potentially high supplier
markup
– Fallacy 3: One should integrate in order to obtain the other firm’s
profit.

Conclusion:
Empirical Evidence on Integration
• All the sources of “synergies” described above are theoretically
legitimate…
• Yet, empirical evidence suggests loss for acquiring firms following
acquisition
– Event study evidence
• Average abnormal return for acquiring firm is negative
– “Diversification discount”
• Why?
– Synergies exist but acquiring firms pay too much (winner’s curse,
overconfidence?)
– Acquiring firms neglect sources of “dis-synergies:”
• Clash of corporate cultures, HR practices, routines
– Other, non-profit maximizing motives for managers to engage in
acquisitions?
• Pay/size relationship, manager portfolio diversification, prestige?

Vertical scope of the Firm Session 5 UofC

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