1

MGMT 611-661:MICROFOUNDATIONS
OF BUSINESS BEHAVIOR
Economic Analysis for Business Leaders

Dr. Sharada Vadali

Module 2 Goals 3, 4: Vertical Firm Size and
Vertical Integration
• Goal 3: Discuss vertical firm organization- mechanism- Why is this
important?

• Goal 4: Discuss cons and pros of transacting with separate entities.

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VERTICAL INTEGRATION
These Slides; Chapter 19 BSZ; Pages 455-456
Samuelson
Chapter BSZ: 19 pp: 631-666 (green page numbers)

PMBA MGMT 611-661

Theory of the Firm & Transactions Cost

The firm is a nexus of

contracts…between the main
firm and other firms, customers,
executives, employees,
directors, and shareholders.
Contracts are coordinating
mechanisms and involve one or
more “transactions”.
 5

Vertical Integration-Definitions (Vertical

Boundaries of a Firm)
❑Vertical integration: A firm expands into a different
stage of a value chain in which it already
operates. This can be upstream or downstream->
increase in vertical boundary Vertical boundaries
of the firm identify the extent to which the firm
engages in backward and forward integration
within its industry’s supply chain.
 6

Context –Evaluating Make vs Buy Decisions

Factors

Qualitative Quantitative

Strategic
Bottleneck Production
Expertise/skill value and Costs Cash flows
reduction Capacity
Reputation

❑ Trade offs between costs and benefits of acquiring inputs or services through competitive
markets versus making them internally
 7

Buy/Outsourcing: Choosing along a Continuum

of Options
Hybrid contract-Relational
The good/service includes idiosyncratic
attributes (specific to the buyer), requiri
investment in “transaction specific” asse
(or human capital). Example: Kieretsu

Spot markets Long-term contracts Vertical integration

Purchased at market price Insourcing
with no long-term commitment
(MARKET TRANSACTION)- (NON-MARKET
COMPETITIVE CONTRACT TRANSACTION)
 ❑ Arise anytime there is an exchange or transfer.
❑ Depend on how the transaction is organized
❑ Internal exchange costs: Costs associated with
management & input procurement costs
❑ External exchange costs:
Transaction Costs: ❑ 2 (or more) separate businesses: television
External & Internal Costs manufacturer and parts supplier.
to an Organization ❑ Costs to create the contract agreements to
transfer parts (in this example), monitoring and
Ronald Coase (1991 nobel
Prize)
source selection. (So costs over and above
Olliver Williamson: 2009
the amount paid to supplier)
Nobel Prize
https://timelessecon.wordpr
ess.com/tag/the-nature-of-
the-firm/ (Coase)
 Vertical Chain of Production 9

Computers- Porter’s Value Chain

Steps in the vertical chain Support services

1. Raw materials (chemicals, metals,
rubber)
2. Transportation and storage Accounting
3. Intermediate-goods processors
(plastics, chips, operating
Finance
software)
Human resources
4. Transportation and storage
5. Assemblers (PC manufacturers) Legal
6. Transportation and storage
Marketing
7. Retailer distribution and service
(computer stores)
Other support services
Vertical Non-Integrated Businesses

Supplier 1 Supplier 2 Supplier 3 Upstream/Backward

The Firm

Distributor 1 Distributor 2 Distributor 3 Downstream/forward

Consumers
 11

Horizontal Integration (and Vertical Integration)

Vertical
Retailer

Acquisition
Wholesaler

Distributor

Merger
Manufacturer

Raw material supplier

Raw materials producer

 12

Vertical Integration Case Examples

2014: Apple acquired

PrimeSense
(Semiconductors)
$345 million & LuxVue
Technology (microLED
technology) – more
flexibility in
manufacturing
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liable to be brought to account

Conditions Amenable for Non-Market Transactions

1. Firm “specific” assets- highly specific to your business Vertical merger

2. Measuring quality costs (information asymmetry) Quality control as potential transaction

cost

o Market firms may have an incentive to provide lower quality inputs

3. Controlling externalities (reputational)
o If reputation is important, outside distributors may have an incentive
to “free ride” on the quality of the products they distribute
4. Extensive coordination
o Difficulties in coordinating for sharing
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Incentive Issues: Specific Assets and Supplier

Hold Ups (Hart , 1995)
❑Supplier Holds up a Contract ➔ raise price on account of
the investment (External exchange cost)
1.The prospect that if you have a specific asset you can hold
my firm a. creates incentives for your firm (b. positive or
negative or both kinds of incentives)
2.Solution: c. Ownership can stop hold-up. d. Using formal
instruments (contracts or asset ownership)
• GM signed a contract
with Fisher Body to
provide it with closed
metal bodies.

• 1920s: unexpected
increase in demand.

• The contract was cost-

plus: GM pays 17% over
and above any non-
capital costs.
• Fisher had incentive to
build new plants further
away from GM’s plants,
so that they could profit-
hold up Fisher Body

• Solution: a merger
between GM and Fisher.
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Vertical Integration –Netflix Own Content Development

Case To Avoid Being “Held Up” by Hollywood
❑Netflix works with ~ 600 Internet Service Providers in
the world
❑~ 55 million subscribers
❑~ average length of subscription 43 months
❑Loyalty development: Quality shows “ Stranger
things”: Developing “own content”: “Narcos” (French
Firm in Bogota: Brancato and others) instead of
depending on Hollywood production companies.
 17

Asset Specificity, Uncertainty, and the Procurement

Decision

Demand Uncertainty
Low Medium High
Asset Specificity

Market Market Market

Low transaction transaction transaction

Contract or Contract or
Medium Contract vertical vertical integration
integration

Contract or Vertical
High Contract vertical integration
integration
DOUBLE MARK-UPS-
SECOND ISSUE
Chapter BSZ: 19 pp: 631-666 (green page numbers newest
edition)
Double-marginalization (aka Double mark up):
External Exchange cost
❑How does monopoly power work in vertical markets?
❑What is the double marginalization problem?
❑How can we fix the double marginalization problem?
❑ Problem associated with “exclusive franchise territories”-
territorial monopolies assigned to one retailer (monopoly property
right preventing intra-brand competition)(auto dealerships,
electronic retailers, fast food franchises)
Double Marginalization
❑Consider two independent firms, A- upstream and B-
downstream, that each have market power
❑Each firm then prices at a mark-up over marginal cost.
❑Recall: markup= (P-MC)/P (aka Lerner Index)
❑Note: Pricing above MC yields deadweight losses AKA, Loss gained from trade

❑Now these are being incurred twice!

Double Marginalization- One Solution
❑If upstream (Firm A) and downstream (Firm B) merge, then A
ceases to try to capture surplus from downstream Firm B.
❑Upstream prices (transfers) at MC.
❑One deadweight loss eliminated!
Double Marginalization Problem Analysis (Retail-
Wholesale) (DM Worksheet)
Retail
Price Retail Demand
12

12 Quantity
Double Marginalization Problem (Retail-
Wholesale)
Retail
Price
12

Marginal Revenue

12 Quantity
 Double Marginalization Problem
MR curve of Retail
firm is Demand curve
(ARw) for wholesaler!
Retail
Price
P=12-Q (Retailer 12
demand)
MC=4 (for
wholesale/produc
er)
4 Marginal Cost
MR=12-2Q
(demand for
wholesaler Arw)
QC = 12 Quantity
8
Double Marginalization Problem
Retail
Price
12

Marginal Cost

QM = 4 QC = 12 Quantity
8
 Double Marginalization Problem
Retail
Price Wholesale profits: the rectangle:
P=12-2Q (demand for (margin $8-$4)*2
wholesaler Arw) 12
MC= 4
MR(w)=12-4Q
Qw = 2 8 Wholesale Price
Pw=8 Wholesale
Margin
4 Marginal Cost

QC = 8 12 Quantity
QDM =2 QM =4
Double Marginalization Problem
Retail
Price Retail profits
12
Retail 10
Margin Wholesale Price
8

4 Marginal Cost

QDM = 2 Q C=
12 Quantity
QM = 4
8
Key Point
❑Everyone is worse off under double marginalization
❑Firms are worse off in terms of industry profits:
❑Under Double Marginalization
❑2 units x ($10 - $4) = $12
❑Under Monopoly
❑4 units x ($8 - $4) = $16

❑Solutions vertical integration, competition downstream and

quantity forcing via sales quotas.
Consumers Are Worse Off Too
Retail
Surplus Under double marginalization
Price
12 DWL under DM
X
Wholesale Price

Z
Y Marginal Cost

QDM QC 12 Quantity
QM
Consumers Are Worse Off Too
Retail
Surplus Under monopoly
Price
12
DWL under
Monopoly
Wholesale Price

Marginal Cost

QDM QC 12 Quantity
QM
Consumers Are Worse Off Too
Retail
Surplus Under monopoly
Price
12
DWL under
Monopoly
Wholesale Price

Marginal Cost

QDM QC 12 Quantity
QM
Wrap Up
❑ Vertical integration is the firm’s process of growing
vertically in size through cost efficiencies (and other
efficiencies)
❑ Involved with ownership in lieu of purely outsourcing
❑ Seeks to address 2 key incentive problems (hold ups and
double marginalization) and associate consumer welfare.
❑Not a complete panacea.
The steeper the leraning curve the greater to protect my learnings and source competitive advantage hence more incentives for vertical integration