Vertical Scope of the Firm

What are the appropriate (efficient)

organizational boundaries of the
firm?
 Transaction Costs and
the Scope of the Firm
In relation to each dimension of scope, the basic issue is relative
efficiency of the single firm compared with several specialist firms.

VERTICAL PRODUCT GEOGRAPHICAL

AREAS
V1
SINGLE V2 P1 P2 P3 A1 A2 A3
FIRM V3

SEVERAL V1
SPECIALIZED V2 P1 P1 P1 A1 A2 A3
FIRMS
Common Issue: What V3are transactions costs of markets compared
with administrative/governance costs of the firm?
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

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Voigt, Fall, 1998
 Creating Efficiently Designed
Corporations

The corporate hierarchy will be efficient when it can be shown to

be the organizational arrangement that minimizes the sum of
production and governance costs. Production costs are the direct
costs incurred in the physical production and exchange of the
item subject to the transaction. Governance costs include costs
of negotiating, writing, monitoring, enforcing, and possibly also
bonding to the terms of the organizational arrangement.

Historically, production costs were the primary drivers of firm

boundaries. More recently, attention has been placed on
governance costs.
Source: Collis and Montgomergy, Corporate Strategy, 1997

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 Defining Vertical Integration

Vertical integration (VI) is a firm’s ownership of vertically

related activities.

Vertical integration can occur in 2 directions:

• Backward Integration (producing own inputs)

• Forward Integration (disposing of own outputs)

Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

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Voigt, Fall, 1998
 Benefits of Vertical Integration

Economies of combined operations

Economies of internal control and coordination
Assure supply or demand
Better quality control and coordination
Protect proprietary technology
Gain access to information
Avoid costs of dealing with the market
Gain (or offset) market power

Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

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 The Costs of Vertical Integration

Differences between stages in optimal scale of operation

Managing strategically different businesses
Agency costs
Higher capital investment
Reduced Flexibility
• in responding to demand uncertainty
• in responding to changes in technology, customer preferences, etc.
Foreclose access to outside information/technology
Dulled incentives
Costs of bureaucratic hierarchy
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

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Voigt, Fall, 1998
 Benefits of the Market

Informational efficiencies i.e. price mechanisms and decentralized

decision-making
Powerful incentive mechanisms i.e. better alignment self-interested
behavior and incentives

e.g. Direct production costs of individual proprietors transacting with

one
Source: Collis another
and Montgomery, onStrategy,
Corporate the 1997
market will be lower than those involving
employees inside a corporate hierarchy.

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Voigt, Fall, 1998
 Costs of the Market:
Transaction Costs and Market Failures

Market relationships fail when they are subject to:

• Opportunism (lying, cheating, stealing, acting self-interestedly)
• Asset specificity (small numbers) (Location specificity,
physical asset specificity, and human asset specificity)
• Uncertainty (inability to predetermine all future eventualities)
• High Frequency (repeated exposure to hold up)
It is the possibility of firms acting opportunistically that causes
market failure. The other three conditions create the opportunity
for a firm to act opportunistically.
• Other Sources include resource inseparability,
information impactedness, and market power

Source: Collis and Montgomery, Corporate Strategy, 1997

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 The Choice between Market and Hierarchy

MARKET HIERARCHY

Informational Efficiencies Authority

BENEFITS High-Powered Incentives Coordination

Transaction Costs Bureaucracy

COSTS
Market Power Agency theory

Source: Collis and Montgomery, Corporate Strategy, 1997 Vertical Scope of the Firm 9
Voigt, Fall, 1998
 Factors that are important in determining the merits of
vertical integration compared to market transactions

How many firms are there in the The fewer the companies, the greater vertically related
activity? the attraction of VI.

Do transactions-specific investments The greater the requirements for

need to be made by either party? specific investments, the more
attractive is VI.

Does limited availability of information The greater the difficulty of specifying provide
opportunities to the contracting and monitoring contracts, the greater firm to behave
opportunistically (i.e., the advantages of VI. cheat)?

Are market transactions subject to taxes VI is attractive if it can circumvent and

regulations? taxes and regulations.

How much uncertainty exists with regard Uncertainty raises the costs of writing to the
circumstances prevailing over the and monitoring contracts, and period
of the contracts? provides opportunities for cheating, therefore increasing the
attractiveness of VI.
Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

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 Factors that are important in determining the merits of
vertical integration compared to market transactions

How uncertain is market demand? The greater the demand uncertainty-- the more
costly is VI.

Are the two stages similar in terms of The greater the dissimilarity in scale-the optimal
scale of operations? the more difficult is VI.

How strategically similar are the different The greater the strategic dissimilarity
stages in terms of key success factors the more difficult is VI. and the
resources and capabilities required for success?

Does VI increase risk through requiring The heavier the investment heavy
investments in multiple stages requirements and the greater the and
compounding otherwise independent risks at each stage --the
independent risk factors? more risky is VI.

Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

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 Intermediate Forms of Organization: A
Continuum of Governance Arrangements

RANGE OF INTERMEDIATE FORMS

SPOT INTERNAL
MARKET HIERARCHY
(full integration)
LONG-TERM STRATEGIC JOINT QUASI-
CONTRACTS ALLIANCES VENTURES VERTICAL
INTEGRATION
(PARTIAL
OWNERSHIP)

Intermediate relationships may combine the benefits of

both market transactions and internalization

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 Different Types of Vertical Relationships
Low Degree of Commitment High

Low Informal
supplier/
customer Vertical
relationships integration
Supplier/
Formalizatio

customer
Spot sales/ partnerships
n

purchases Joint
ventures
Agency
agreements
Long-term Franchises
contracts
High

Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

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Voigt, Fall, 1998
 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?

Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

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 Recent Trends in
Vertical Relationships (US)

From competitive contracting to supplier partnerships

(e.g. auto industry).
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.

Source: Robert M. Grant, Contemporary Strategy Analysis, Basil Blackwell, 1995

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 JAPANESE APPROACH

Extensive use of subcontracting

Mitigate opportunism via:
• equity links
• personnel links
• long-term relationships
• implicit contracts
Close coordination of suppliers and assemblers
• product design
• JIT delivery

Source: Mari Sakakibara, UCLA, 1997

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 Flow Chart for Vertical Integration Decisions

MARKET CONTRACT
YES

INCENTIVES
AGENCY
COSTS

RENT NO HOLD-UP NO
APPROPRIABILITY TRANSACTION
TRADEOFF
COSTS

COORDINATION
FIAT

YES YES
YES
INSIDE HIERARCHY Vertical Scope of the Firm 17
Voigt, Fall, 1998
 Action Steps in Scope of Firm
Decisions

Step 1: Disaggregate the Industry Value Chain

Step 2: Competitive Advantage
– Do you have a competitive advantage in the performance of the
activity?
Step 3: Market Failure
– Is there a clear market failure? Are the costs of market
governance extremely high? Can dominant firms exercise
market power?
Step 4: Need for Coordination
– Is there an ongoing need for intensive coordination? Are
continual and integrated changes required? Is there a distinct
interface between activities?
Source: Collis and Montgomery, Corporate Strategy, 1997

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Voigt, Fall, 1998
 Action Steps (cont’d)

Step 5: Importance of Incentives

– How high are agency costs inside the hierarchy? How
much do worker skill and effort affect outcomes? Can an
effective incentive scheme be designed? Which is more
important: coordination or high-powered incentives?

Source: Collis and Montgomery, Corporate Strategy, 1997

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 Summary: Creating Value in Vertical
Activities
Be Better Than Competitors
(1) In determining whether activities should be internal or external:

External Internal Activities External

Supplier Customer

(2) In coordinating these activities along the value chain:

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Voigt, Fall, 1998
 General Conclusion

Ross Perot to GM Management:

“You don’t need to own a dairy to

buy milk.”

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