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.

SINGLE
FIRM

VERTICAL

PRODUCT

V1
V2
V3

P1 P2 P3

GEOGRAPHICAL
AREAS
A1 A2 A3

V1
SEVERAL
P1
P1
P1
A3
A1
A2
SPECIALIZED
V2
FIRMS
V3
Common Issue: What are 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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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 firms 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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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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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
another
onStrategy,
the 1997
market will be lower than those involving
Source: Collis
and Montgomery,
Corporate
employees inside a corporate hierarchy.

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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

BENEFITS

COSTS

HIERARCHY

Informational Efficiencies

Authority

High-Powered Incentives

Coordination

Transaction Costs

Bureaucracy

Market Power

Agency theory

Source: Collis and Montgomery, Corporate Strategy, 1997

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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
need to be made by either party?
attractive is VI.

The greater the requirements for

specific investments, the more

Does limited availability of information

provide opportunities to the contracting
firm to behave opportunistically (i.e.,

The greater the difficulty of specifying

and monitoring contracts, the greater
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?

costly is VI.

The greater the demand uncertainty-- the more

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
MARKET
LONG-TERM
CONTRACTS

STRATEGIC
ALLIANCES

JOINT
VENTURES

QUASIVERTICAL
INTEGRATION
(PARTIAL
OWNERSHIP)

INTERNAL
HIERARCHY
(full integration)

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

Formalizatio
n

Low

Informal
supplier/
customer
relationships

Vertical
integration

Supplier/
customer
partnerships

Spot sales/
purchases

Joint
ventures

Agency
agreements
High

High

Long-term
contracts

Franchises

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

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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
APPROPRIABILITY

NO

HOLD-UP
TRANSACTION
COSTS

NO

TRADEOFF

COORDINATION

FIAT
YES

YES

INSIDE HIERARCHY

YES

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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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Action Steps (contd)

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
Supplier

(2)

Internal Activities

External
Customer

In coordinating these activities along the value chain:

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Voigt, Fall, 1998

General Conclusion
Ross Perot to GM Management:
You dont need to own a dairy to
buy milk.

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