Chapter 9:

Vertical integration and Transaction Cost

Essential Reading
Besanko, D., D. Dranove, M. Shanley and S. Shaefer Economics of Strategy.
(United States, Wiley, 2006) Chapters 3 and 4.

Further Reading
Cabral, L.M.B. Introduction to Industrial Organization. (United States and
United Kingdom, MIT Press, 2000) Chapter 3.

Learning Objectives
By the end of this chapter you should be able to:
• link ‘core competencies’ and ‘distinctive capabilities’ to the vertical
relations and the value-based strategy literature
• understand and explain the sources and types of transaction costs.

Key Concepts
• Asset Specificity
• Co-ordination Cost
• Hold-Up
• Make or Buy
• Purchasing versus Production Cost
• Quasi-Rent
• Transaction Cost

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Introduction
Building on the previous chapter, the incentives for foreclosure are often
only one part of the decision to make or buy a particular input.

In fact, many firms are not even in the position to foreclose entry
strategically or exploit their market power vis-à-vis competitors and/or
suppliers or buyers.

Most frequently, the decision to make or buy is governed by cost

considerations, although assessing these costs is often more intricate than
simply comparing the price of the input on the free market with the cost of
producing in-house. In this chapter, we will briefly discuss the different
costs and how firms can influence or avoid them.

Purchasing versus Production Costs

Firms often feel they are paying too high a price for inputs bought
externally.

However, if the alternative is producing the input at a higher cost than the
market price, then buying in still makes economic sense.

In other words, if the market price (including a mark-up for the supplier) is
still lower than the internal production cost, a firm should ‘buy’ rather than
‘make’.

This could be the case if there are significant economies of scale of

production that do not apply at the quantities demanded by the firm – as can
be seen in Figure 9.1.

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Figure 9.1

Firm i would only produce a small amount itself, while the supplier could
take advantage of economies of scale, collect a mark-up and still offer the
product cheaper than firm i could produce it internally.

These economies of scale could come from ‘true’ benefits to scale, such as
production economies, but they could also originate from greater
specialisation by the input suppliers.

For example, outsourcing of business processes such as payroll services has

the advantage that a firm specializing purely in payroll systems will be better
at it than a firm with a different focus.

As we have established in the previous chapter, the effect will be weakened

by the degree of competitiveness of the input market.

If it is relatively competitive, market price will be closer to marginal cost,

which means that a firm would have to produce even larger quantities to
‘beat the market’.

(This can also work the other way if the market is a natural monopoly and
the economies of scale are so strong that prices are higher with two smaller
operators than with a single monopolist.)

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Co-ordination Costs
This cost is often ignored in the calculation of total purchasing cost –
informally, we could call it the loss of ‘peace of mind’ when purchasing
from an outside supplier.

It basically stems from the fact that suppliers will have priorities other than
you if the contract does not allow for the cost of delay, or a faulty product,
would have for you.

Consider a simple example: a restaurant requires its produce and meat to be

delivered by
2pm, and the contract it signed with its suppliers states that every hour’s
delay will incur a contractual penalty of $x.

Suppose now that the cost of a one-hour delay is $y < $x, but a two-hour
delay would mean that the chef has to rush preparations or even purchase
meat from another source.

The cost of delay therefore increases dramatically, and two hours’ delay
means a cost to the chef of $z > $2x. Can this be a problem?

If every restaurant requested delivery at 2pm, it might make sense for the
supplier to deliver orders along the most convenient (and cost-efficient)
route – which could mean that our chef receives the delivery an hour late,
which is not a problem as such since the penalty of $x covers the extra cost
of $y and, assuming that the supplier obtains a cost saving of at least $x,
everybody gains from this rescheduling of deliveries.

But suppose that an additional hour’s delay would give the supplier another
cost saving (or additional job he can take on) of equal size (> $x), he would
be willing to pay another hour’s penalty, which would send the chef into a
(costly) panic which would not be covered by the additional penalty
payment.

In the example above, the problem is that the penalties do not increase
according to the real cost to the restaurant – the key insight is that by
purchasing externally, it is important to realise that the supplier’s incentives
will be different to that of any one individual firm.

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Of course, a similar argument would also be true for the quality of an input.
If the incentives to cut corners for a supplier are not adequately offset by
severe enough controls or contractual penalties, it might lead to a situation
where a supplier produces with a higher tolerance for small imperfections
and willingly takes the penalties into account because they are outweighed
by the cost savings achieved.

In the extreme, if the cost of delay, faults and so on are prohibitively high, a
supplier might not even be willing to enter a contract that would adequately
reflect these costs. If the risk is too high, a supplier might prefer not to take
the risk, and compensating the supplier for it would be prohibitively costly.

Proprietary Knowledge
Frequently, making or buying a particular input is not governed by a
calculation of the cost, even if the costs of producing in-house are very high
and there is a ready and competitive supply on the market.

For example, one might argue that there are plenty of small research
laboratories (or at least a number of entrepreneurial scientists) that would be
able to offer outsourced research services to larger organisations. (In fact,
this is already happening to a certain extent, but the majority of research-
intensive firms will still do their research in-house.)

The key reason is that the closer an activity is to the core competencies (or is
a distinctive capability) of a firm, the more concerned the firm will be to
protect this intellectual property.

While it is still possible for employees to leave and take company secrets
with them, there is a much larger degree of control over in-house activities
than outsourced activities, so if the firm wants to protect proprietary
knowledge, it is likely to keep activities in-house.

A particular case of knowledge kept in-house is the control over the

selection of staff – again, companies performing outsourced business
functions are often motivated by different performance targets (their own!)
than the organisation that outsources.

However, keeping knowledge in-house need not be a distinctive capability

or crucial to the firm’s success. For example, information about demand for

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one firm’s product might also be transmitted via supply prices and delivery
schedules to rivals.

The danger of having rivals learn about the success of a particular market or
product then might prompt a firm to produce inputs in-house.

Transaction Costs
The term transaction costs define those costs arising from an exchange
relationship – which could be governed by a written contract or an implicit
or relational contract. Again, there are direct costs and indirect costs –
indirect costs may often affect the value of a transaction more significantly
than direct ones.

Direct costs are the time spent on specifying a contract, lawyers’ fees for
drawing up the contract, writing job descriptions and so on. Most often,
these will be much lower within the firm than on the market – predominantly
because a contract need not be written. Another direct cost would arise from
monitoring the quality of the exchanged product and from the cost of faulty
items – if someone has to spend time and effort removing faulty products
that the other party has delivered and if this screening process is not perfect,
costs arise from completing this specific transaction.

Indirect costs are more difficult to quantify, but they often have more
bearing on the decision to make or buy – if indirect transaction costs are too
high ‘it’s just not worth the effort’. Indirect costs mainly arise from the fact
that contracts are incomplete in the sense that they do not specify precisely
what should happen (or what both parties are obliged to do) for any possible
contingency in the market.

If a situation arises that has not been specified in the initial contract this is
then subject to haggling and negotiations, and the expected losses from the
partners behaving opportunistically.

Both parties will have to take into account that incentives are not perfectly
aligned and that the other party will try to maximise its own pay-offs if the
finer points of the contract allows. Insurance for many types of natural
disasters are subject to large uncertainties in the determination of damages
and payouts.

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For example, Hurricane Katrina had (and still has) insurance companies and
insured parties in bitter fights because many policies exclude water damage,
but include wind damage – it is now a matter of interpretation if the damage
to property has been caused by the severe winds or tidal waves – and
naturally both parties claim the outcome most favourable to them, which is
surely going to generate a significant revenue stream for the legal
profession. For a discussion of the legal conundrum surrounding Hurricane
Katrina, see
www.insurancejournal.com/news/southeast/2005/09/27/60219.htm

Generally, indirect transaction costs are higher in market transactions

because the incentives are less aligned than within the firm. This implies that
if a contract cannot be specified well so that a large (and costly) number of
contingencies cannot be catered for, relationships are likely to be within one
firm.

Both elements of transaction costs are important – for example, it is easy to

imagine that a homeowner expecting to incur huge legal costs to secure a
payout following a natural disaster will decide not to take out insurance
despite the direct transaction cost being relatively small, with a standard
contract being offered over the phone, for example.

Activity

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Using transaction cost arguments, explain why research and development is
often kept inhouse, while firms purchase options to hedge against currency
risk.

Solution

By keeping research and development in-house, a firm can reduce direct and
indirect transaction costs.

• direct costs:
o lower costs on specifying and drawing the contract
o better quality because of the higher motivation of the
employees (reduction of costs for quality monitoring)
o the result of R&D is more suitable for the firms’ requirements

• indirect costs:
o opportunistic behaviour can be widely excluded because the
employees are more aligned with the firm
o unexpected situations can be solved faster

Asset Specificity
Closely related to the discussion on vertical relations is the concept of asset
specificity. An asset is said to be specific if it has significantly less value
outside one particular relationship than it has within it.

A specific investment changes the dynamics of a relationship or transaction

quite significantly: the moment the investment has been made, the investor
is now vulnerable to opportunistic behaviour by its contractual partner.

Basically, before investing, anybody could have entered the same transaction
on either side. On the other hand, after the investment, the two parties are
bound together – this is what is called the fundamental transformation from
a ‘large-numbers bidding (or market) situation’ to a ‘small-numbers
(bilateral) bargaining scenario’.

Fig. 9.2

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Once the parties invest in relationship-specific assets, the relationship
changes from a “large numbers” bidding situation to a “small numbers”
bargaining situation.

Why is this problematic? In a market situation, everybody can walk away

from a deal that does not seem favourable. In a situation where an
investment has already taken place, this is a lot harder.

Contractual parties will take this into account and, if possible, will try to
exploit this by holding up their partner:

Definition
Hold up – If a contract is incomplete, party A can hold up B by trying to
renegotiate the initial agreement in its favour if leaving the contact
unfulfilled would involve significant costs for B and little for A.

The important concepts in this definition are the contractual incompleteness

and the difference in costs – if the contract is incomplete, there is space for
renegotiation, if it is complete, any attempt to change the terms could simply
be stopped by insisting on the initial terms of the contract.

However, not many contracts are complete. The reasons that we do not fear
being held up in all incomplete contracts is that the costs of not fulfilling the
contract are often relatively symmetric – a producer stands to gain revenues
from selling a product and a consumer stands to enjoy use of a product,
which makes trade between the two mutually beneficial.

On the other hand, if one party depends on this particular contract while the
other has plenty of alternative options (or simply is not that bothered about
this transaction) there is some scope for hold up.

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The term to describe the degree of dependency on this particular transaction
is the concept of quasi-rent. Therefore, if one player has high quasi-rent and
one has not, the former is typically in danger of being held up.

Definition
Quasi-rent is the difference between the revenue the seller expects to
receive under the initial terms of the contract and the minimum revenues the
seller must receive in order not to exit the relationship.

Activity

Rank the following four investments in terms of their asset specificity and
explain why.

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Explain who makes the investment and who benefits from it.

a. A wind energy turbine is designed and built according to a terrain’s

specific features.

b. A McDonald’s franchisee builds a ‘Ronald McDonald Playground’ in the

back of the restaurant.
c. McKinsey offers a mini-MBA to its new employees.

d. A firm invests in a high-performance server to improve the productivity of

its logistics and distribution.

Solution

a) The turbine fits exactly to a certain terrain; in different surroundings it

would have much less value. The only one who benefits from the investment
is the investor (energy provider) itself.

b) Although the franchisee makes the investment, the benefit goes to

consumers, the franchisee, and McDonald’s itself, because the dining
experience is made more pleasant and the likelihood of customers returning
is therefore higher.

c) The investor is McKinsey; it benefits from the mini-MBA because the

employees are better qualified as a result of the programme.

d) The server is customised to the firm´s needs and thus has less value
outside this relationship. The investor is the firm that implements the server.
The firm and its customers benefit from the investment.

Alternatives to ‘Make’ or ‘Buy’

We increasingly see firms choosing alternatives to pure vertical integration
or exclusive market contracting. Described below are a number of
alternatives.

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Joint Ventures and Strategic Alliances
As discussed, strategic alliances and joint ventures are often initiated over
several stages of the value chain – as an alternative to vertical integration.

The main difference lies in the nature of contracts between the partners –
while vertically integrated firms will typically get by without formal
contracts between units, the most important contractual element is the
employment contract, which will often include an element of monitoring so
that the firm’s interests are secured, and a degree of performance pay so that
employees will have their incentives aligned with the firm.

A market transaction on the other hand is governed by an exchange contract

that specifies the terms of delivery and so on. Strategic alliances and joint
ventures are in-between in that they sometimes have an element of joint
asset ownership (in the case of joint ventures) and always a degree of
(formal or informal) profit sharing, which is used to align incentives.

This makes joint ventures and strategic alliances a hybrid form since there is
no authority in the same way as in an employment contract, but no fully
specified contract as in a market transaction.

Sub-Contracting Networks and Franchising

Another alternative is to build and maintain sub-contracting networks and

engage in franchising.

In some senses, this is similar to a market transaction as the contracts try to

specify the terms of sub-contracting and so on, as much as possible with the
main difference being that in both cases (sub-contracting network and
franchising) there is a relational element to the contract.

A franchisee would not enter the relationship and invest accordingly if he

did not expect the relationship to continue for some time, very often beyond
the end date of the initial franchising contract.

The long-term outlook and relational element will make it easier and more
attractive to invest in the relationship for both parties.

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Another reason why such networks do not seem to trigger fears of being held
up by the franchiser is that news of opportunistic behaviour would very
quickly spread throughout the entire network of franchisees, which would
lead to a relatively severe backlash (in the sense of lowered investment by
the franchisees), not only by one franchisee, but by many of them.

Tapered Integration
Tapered integration involves making some input in-house and buying some
on the market. Very often, the rationale given for this is that external
demand can be used to ‘buffer’ demand fluctuations of the input, while the
stable component of demand is produced in-house.

It is important to note, however, that the main difference between tapered

integration and the other two alternatives is that there is no attempt to align
the incentives of supplier and buyer – if anything, incentives are now even
more opposed as the internal input supplier and the external supplier are now
in indirect (or direct) competition for business from the downstream unit.

Another motivation for tapered integration is to lessen the danger of being

held up. If a firm can produce a significant proportion of input demand itself,
suppliers will not be able to hold up the firm by threatening to withhold
supplies.

Questions for Discussion

1. Discuss the relative advantages and disadvantages of the three alternatives
to make or buy compared with vertical integration and/or market
transactions.

2. Why do you think outsourcing is more frequent in mature industries than

in the early stages of an industry’s life cycle?

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Extended Activity
Caselet: Athenahealth, US Healthcare Industry
Based in Waltham, Massachusetts, athenahealth is an IT provider in the
healthcare industry that offers Internet-based revenue-cycle management
services to physician enterprises – hospitals and doctors in private practice.

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Founded in 1997 by Jonathan Bush, Chairman and CEO, and Todd Park,
Chief Development Officer, athenahealth achieved sales of nearly $40
million in 2005. The company’s mission is to get health care to work the
way it should – so that information is conveyed efficiently and accurately to
the benefit of both patients and doctors. athenahealth is backed by bluechip
venture capital firms in the US, including Venrock Associates, Oak
Investment Partners and Draper Jurvetson.

athenahealth began not as a technology company but as a women’s health

practice focused on improving maternity outcomes for women and babies.

The idea for the company took hold when Bush, a recent graduate of
Harvard Business School, met Park at the consultancy Booz-Allen &
Hamilton where both worked as associates focused on the healthcare sector.
With entrepreneurial spirits high, they set out to build this business, but soon
found their goals thwarted by something seemingly very basic: getting paid.

‘athenahealth was born from our struggle of actually running a group

practice, when the Herculian effort and complexity of getting paid started
taking time away from patient care. The practice delivered high-quality
patient care, but the mounting red tape from payers meant cash flow was
volatile at best. We couldn’t get paid and we didn’t know why.

‘When we started researching solutions, we only found companies selling

hardware and software but nothing that could help us get the results we
hoped were possible. These companies couldn’t give us back control of our
practices.
We decided to tackle the problem ourselves and build a true revenue cycle
management solution—one that is used by thousands of US physicians
today’ (athenahealth web site).

To date, athenahealth has been focused on developing and rolling out an

electronic billing solution that, by running back-office processes more
efficiently, boosts doctors’ profitability and power, particularly vis-à-vis
insurance companies. With this foothold firmly in place, the company is
now applying their skills in process control to the clinical side of a medical
practice – tracking lab orders, results and prescriptions, and streamlining the
medical group’s interface with these players.

15
Talking with Mr Bush reveals his vision of transforming the entire supply
chain in the healthcare industry from a flabby and fragmented consortium
into a system that ultimately delivers enormous cost savings and vastly
improved health care to patients. The company’s strategy remains focused
on medical groups as its primary customers, helping them become strategic
entities that, through gathering momentum, influence the way every other
player in the supply chain acts and interacts.

Excerpts from a conversation with Jonathan Bush about athenahealth

and the future structure of the supply chain in the US healthcare
industry:

‘Everything in health care comes out of an order from a doctor.

The order-making engine is the doctor. Associations of physicians create an
artificial shortage of their expertise so that they can charge higher prices –
and it works. The people who get to decide how many people in the guild
there should be are the specialists in that specialty. So the doctor gets to
control the original supply of the order-making entity. It’s called great work
if you can get it. If you were a taxi driver, you would really like to control
how many taxis are competing for fares, right?

‘When you look at a supply chain, you want to look at where’s the fat,
where’s the place where there is extra value created because everything is
supposedly getting pushed toward commodity prices all the time. Well the
doctor gets to control supply so he doesn’t get pushed so he isn’t forced to
merge with other doctors or to get economies of scale in his office, because
he can actually make a pretty tidy sum with a lady and a little one-shingle
office.

‘When you look at organisational scale in the supply chain, you see that in
the first link in the supply chain—the average office has three doctors in it!
That’s averaging in the Mayo clinic and all the mega clinics– 55 per cent of
medical doctors in the United States are practising in groups of one or two
doctors. So there is not a lot of efficiency and scale in the entity that is
creating the orders that then flow through the rest of the system.

And so our first step is to help doctors in private medical practices go from a
guild to an operating entity, helping them to achieve basic efficiencies in the
information infrastructure.

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‘Our second step is to move medical groups from an operating entity to a
strategic entity. So once you – the medical practice, the order-making entity
– have basic internal integrity where you know how many orders you sent
out, you know how many results came back, you know how many claims
you sent out, you know how many got paid, how many didn’t, whether they
got paid enough – that basic stuff – then you can use that integrity to move
from being an operating to a strategic organisation. You are choosing when
to fight and where.

A strategic organisation is in the business of looking through the things they

do and picking and choosing – I only want to see patients with this or that
insurance company versus this other one, or I want to do my own pap smears
with my own laboratory because it seems like there’s a lot of money to be
made there. So they are making decisions around what in the supply chain
around me do I want to control, and what in the supply chain around me do I
want to avoid.

So that’s the second thing that we want to help medical practices do.
‘And the third thing that medical practices don’t do – but will do some day –
is go from being a strategic entity to a system where they actually use their
market power to influence what happens elsewhere, in part by co-ordinating
with other medical practices.
An example of different entities becoming operating entities, and then
strategic entities and then a system is the Visa network. All the different
merchandisers in the visa network have agreed to be a system – they have
agreed to create this not-for-profit called the Visa association that clears the
transaction. Anybody who wants to issue credit on a retail basis can use this
really efficient network, where, for pennies a customer can stick her card
into any slot in the world and
somebody’ll figure it out.

Sometimes it’s debit and sometimes it’s credit, all you know is you shove
the thing in and the money comes out. ‘So that is the last step in the journey
of that order-making entity.

Fundamentally we are still stuck at the guild level. We are in the business of
moving physicians from guilds to operating entities to strategic entities, and
we believe that someone will come along and build a system using athena as
an ingredient. And the reason is because we have integrated all of the

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technology, knowledge and work that go into the mechanics of an order into
a solution that doesn’t have any upfront costs.

Just like the visa network. When you’re a store and you want to take Visa
you don’t have to go buy some software into a computer and install it to
capture the Visa network. Visa says, “ok it’s going to cost you 3.5 per cent
of all the transactions you do and we’ll show up, we’ll show you how it
works, we’ll help you open your account, and we’ll be watching, and as we
deliver value to you, we’ll take our piece.”

[Indeed, what differentiates athenahealth from competitors is its decision to

share risk with customers by charging a percentage fee of a doctor’s
collections, rather than a flat fee.]

‘So what athena is doing is for the first time providing a valuebased service
like that, which integrates all of the software, hardware, the subject matter
knowledge, what type of insurance does this person have, what drug are you
ordering, is that something they are allergic to, or is it consistent with other
drugs they are already on. We are responsible for what software needs to be
written, what hardware it needs to sit on, what knowledge, what resources,
insurance or laboratories that are available for the doctor to interact with. We
aim to formalize and disaggregate the supply chain so that there is
essentially a reliable grid through which orders and results are trafficked. To
make a fiduciary platform, a national backbone that makes sure those things
are cleared properly. We believe that doing this will create a lot of potential.

‘To begin with, it will create a lot of savings for everybody. Right now we
do everything twice. We send out every lab twice, we send out every claim
two and a half times, we fill out every prescription 1.8 times. It is all manual
and it is all coming out on paper charts in the offices of teeny tiny doctors
who don’t have any really strong need to integrate. When a doctor orders
something, he or she expects a result to come back, and 30 per cent of the
time it doesn’t. That affects patient care pretty dramatically. In the US we
killed 96,000 people in the last year by accident by misreading or mis-
transcribing information.

If the airline industry had the same fatal error rate as the healthcare industry,
there would be two jumbo jet airliners crashing into each other every third
day of the year killing everyone aboard both planes – by accident!

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‘Once we’ve established an information infrastructure, it then becomes
possible for doctors to decide their strategic direction.

Maybe they want to be their own lab, maybe they don’t, they can figure it
out. Once doctors become strategic entities, once all of the complexity is
stripped away and it’s reliable, then they can make those decisions; and so
that’s our goal.

To get all of this tough work to go away and then you’re actually looking at
information and you make informed decisions and we’re thinking when that
happens, doctors will integrate, will merge, will see the opportunities of
doing their own surgeries in their centres, and the supply chain will
dramatically re-aggregate. It will go from the general store model of a
hospital that has a total mishmash of whatever it is that the doctor wants
done with no particular idea of whether it works for them or not – to places
that take different parts of the supply chain and do them really well in
competition with others.

‘Everybody in this country has always been interested in whether we can

cure this or that disease, a new stint, or new device, or a new operation but
the truth is we can already do some pretty absurdly elaborate things, we just
can’t reliably give each other flu shots. It turns out that the number of lives
lost, angst caused, humiliation caused by just doing the things that we
already know how to do badly vastly outweighs the lives saved by learning
how to do more things.

And so there’s this gaping hole. ‘We are going medical group by medical
group to grow our business. Remember when you take on the supply chain,
the whole supply chain can be included, but if we don’t have this or that
insurance company or lab wired up, then we have to replicate the manual
work that the lady in the smock used to do in the back office with the fax
machine. At athena, we receive two metric tons of paper every week which
is the stuff that insurance companies don’t give us electronically, and we run
it through scanners to verify the amounts and we run it through the data
centre in India and they punch in all the little numbers on all the little pages
so that they turn it into the electronic information that we should have gotten
in the first place.

We have to replicate the experience of everybody operating in a paperless

world by actually just handling all the paper. We go to an insurance

19
company and say, dude, you give us 65,000 pages of paper a month! You
have to print it, you have to mail it. If you just build an interface, you don’t
have to do anything!

‘You got to get there somehow. Imagine trying to start FedEx, when you got
a million planes flying every day, the incremental cost of another package is
very low…but how do you get to the point where you’ve got a million
planes flying?

We at Athena have been lucky in that with the Internet and India and the
evolution of optical character recognition – all those things have converged
to allow us to burrow into these very cumbersome pieces of the supply chain
without enjoying the luxury of having everybody on the same standard. It
has been a kind of solar eclipse that has made us lean enough, and the
industry as we walk into it is fat enough, that we can wedge ourselves into
the supply chain and still make money.’
Questions
1. Mr Bush talks about how the lack of scale and efficiency in medical
practices, the first link in the supply chain, has been a major factor in
creating the healthcare supply chain as we know it today. He argues that,
with access to information, doctors will become strategic entities that see the
benefits of merging and integrating.
i) Analyse this projection.
ii) What are some of the likely effects such consolidation would have? iii)
Where might the projected sources of economies be?
iv) What might some impediments be?
v) Why do you think this has not happened before?

2. Mr Bush speaks about the ‘guild’ culture among medical practitioners.

Assuming the restraints on supply of physicians remain in place, what
besides empowering through information, could athenahealth be doing to
foster a business culture among practitioners in this unique profession?

3. Mr Bush uses the Visa network as analogy of what athenahealth is trying

to iniate in the healthcare industry.
i) Do you think this analogy is apt?
ii) What are some of the differences between the two systems that might lead
to different outcomes?

4. athenahealth is focused on medical practices as its primary customer.

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i) Analyse this strategy in light of the company’s vision of building an
information infrastructure that includes all players on the supply chain.
ii) If you were Todd Park, responsible for business development at
athenahealth, what strategies would you propose to fasttrack this process?

5. What other businesses started or could be created as a result of problems

or inefficiencies in the supply chain of this or another industry? Brainstorm
to find at least one example and discuss.

Further Reading
The decision of a firm to perform an activity itself or purchase it from an independent firm is
called a make-or-buy decision. "Make" means that the firm performs the activity itself. "Buy"
means it is relying on an independent firm to perform the activity, perhaps under contract.

Typical make-or-buy decisions for a manufacturer include whether to develop its own source
of raw materials, provide its own shipping services, or operate its own retail web site. Note,
when a firm acquires an input supplier, that firm is "making" the input, because it is
performing the activity in-house.

Make and buy are two extremes along a continuum of possibilities for vertical integration.
The following figure fills in some of the intermediate choices.

Close to "make," integrated firms can spin off partly or wholly owned subsidiaries.

Close to "buy," market firms can enter into a long-term contract, tying their interests for
several years. In between are joint ventures and strategic alliances, in which two or more
firms establish an independent entity that relies on resources from both parents.

To resolve the associated make-or-buy decisions, the firm must compare the benefits and
costs of using the market as opposed to performing the activity in-house. The following
summarizes the benefits and cost to buy

Benefits

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  Market firms can achieve economies of scale that in-house departments producing
only for their own needs cannot.

 Market firms are subject to the discipline of the market and must be efficient and
innovative to survive.

Costs

 Coordination of production flows through the vertical chain may be compromised

when an activity is purchased from an independent market firm rather than performed
in-house.

 Private information may be leaked when an activity is performed by an independent

market firm.
 There may be costs of transacting with independent market firms that can be avoided
by performing the activity in-house.

Reason to “Buy” (Outsourcing)

Reasons to use the market, or "reasons to buy," are derived from a simple concept— market
firms are often more efficient (i.e., they can perform the activity at lower cost or higher
quality than the purchaser could if it performed the activity itself).

i) Exploiting Scale and Learning Economies

It is conventional wisdom that firms should focus their activities on what they do best, and
leave everything else to independent outsourcing partners. The logic is that market firms can
perform most activities more efficiently than can integrate firms.

There are several reasons for this.

 First, market firms may possess proprietary information or patents that enable them
to produce at lower cost.

 Second, they might be able to aggregate the needs of many firms, thereby enjoying
economies of scale. When economies of scale or learning economies are present,
firms with low production levels or little experience in production may be at a severe
cost disadvantage relative to their larger, more experienced rivals. Market firms-firms
that specialize in the production of an input-can often achieve greater scale, and
thus lower unit costs, than can the downstream firms that use the input. The reason
is that a market firm can aggregate the demands of many potential buyers, whereas a
vertically integrated firm typically produces only for its own needs.

 Third, they might exploit their experience in producing for many firms to obtain
learning economies.

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ii) Agency and Influence Effects
Market firms enjoy a number of benefits related to incentives. Though difficult to quantify,
these intangible benefits can give market firms an advantage over their integrated rivals.

Agency Costs: Managers and workers make many decisions that contribute to the
profitability of a firm. Examples include how hard to work, how much to invest in
innovation, and how many employees to keep on the payroll.

When managers and workers knowingly do not act in the best interests of their firm, we say
that they are slacking. Agency costs are the costs associated with slack effort and with the
administrative controls to deter slack effort. Agency costs can affect the firm's bottom line,
but within divisions of a large vertically integrated firm, they may go unnoticed by top
management.

One reason is that most large firms have common overhead or joint costs that are allocated
across divisions. This makes it difficult for top management to measure an individual
division's contribution to overall corporate profitability.

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The second reason is that in house divisions in many large firms serve as cost centers. A cost
center is a department or division that performs an activity solely for the firm of which it is a
part. That is, a cost center generates no revenue from outside the firm.

An example of a cost center would be the laundry service in a hospital or the data processing
department in a bank. Cost centers are often insulated from competitive pressures, because
they have a committed "customer" for their inputs. Moreover, it is often difficult to evaluate
the efficiency of cost centers because there is often no obvious market test based on
profitability for judging their performance.

The absence of market competition, coupled with difficulties in measuring divisional

performance, make it hard for top management to know just how well an internal division is
doing relative to its best achievable performance. This, in turn, gives division managers the
latitude to engage in behavior that cuts into corporate profits.

Even when it is aware of agency costs, management may find it less costly to ignore them
than to eliminate them. For example, many firms are unwilling to fire a nonproductive
worker who is near retirement age. This is particularly likely if the vertically integrated firm
possesses some inherent advantages in the market that insulates it from competition and
relieves top management from the pressure of controlling agency costs.

Influence Costs: Firms allocate financial and human resources to internal divisions and
departments through "internal capital markets." If internal capital is scarce, then when
resources are allocated to one division or department, fewer resources are available to be
allocated to others. (Opportunity Costs)

Influence costs are the costs of activities to influence internal capital markets.
Influence costs not only include the direct costs of influence activities (e.g., the time
consumed by a division manager lobbying central management to overturn a decision that is
unfavorable to his or her division), they also include the costs of bad decisions that arise from
influence activities (e.g., resources that are misallocated because an inefficient division
knows how to lobby for scarce resources).

As with agency costs, a large, vertically integrated firm may be prone to influence costs that a
smaller, independent firm might avoid.

Costs associated with “Buy” (Outsourcing)

The three major costs associated with using the market include the costs of poor coordination
between steps in the vertical chain, the reluctance of trading partners to develop and share

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valuable information, and transactions costs. These problems are related to the concept of
incomplete contracts.

i) Coordination of Production Flows Through the Vertical Chain

For coordination to succeed, players must make decisions that depend, in part, on the
decisions of others. Working together, firms can assure a good fit along all dimensions of
production. Examples include:

 Timing fit. The release of movies must be coordinated to coincide with the
advertising campaign.

 Size fit. The sun roof of an automobile must fit precisely into the roof opening.

 Color fit. The tops in Benetton's spring lineup must match the bottoms.

 Sequence fit. The steps in a medical treatment protocol must be properly sequenced.

 R&D fit. Researchers on a given project must accurately share detailed information.

Without good coordination, bottlenecks may arise. The failure of one supplier to deliver parts
on schedule can shut down a factory. A failure to coordinate advertising images across local
markets can undermine a brand's image and dampen sales.

Firms often rely on contracts to assure coordination. Contracts may specify delivery dates,
design tolerances, or other performance targets. If a supplier fails to meet the specified
targets, it might have to pay a penalty. Alternatively, if they exceed expectations, they might
receive a bonus. For example, construction firms often receive a bonus if they finish their
work ahead of schedule. Firms may also assure coordination in the vertical chain by relying
on merchant coordinators—middlemen, independent firms that specialize in linking
suppliers, manufacturers, and retailers.

The use of contracts and middlemen clauses is widespread, yet in some circumstances the
protections afforded by contracts and middlemen may be inadequate. Coordination is
especially important in processes with design attributes, which are attributes that need to
relate to each other in a precise fashion, otherwise they lose a significant portion of their
economic value. For instance, timely delivery of part necessary for manufacturing process to
begin as well as well as matching colors of sportswear ensembles within narrow tolerance.

One characteristic in common among these activities is that a small error can be
exceptionally costly. For example, a slight delay in delivering a critical component can shut
down a manufacturing plant. Contracting firms often understand the importance of
coordination.
Incomplete contracts cannot guarantee coordination. Whether by accident or design, an
upstream firm may fail to take the steps necessary to assure a proper fit, with the result that
the downstream firm suffers substantial harm. If the cost is catastrophic, then the downstream
firm may never be made whole, even if it prevails in court.

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Confronting such a possibility, the downstream firm may wish to integrate all critical
activities. It would then rely on administrative control to achieve the appropriate
coordination, rather than rely on independent firms and hope that coordination emerges
automatically through the market mechanism.

This cost is often ignored in the calculation of total purchasing cost. Informally, we could call
it the loss of ‘peace of mind’ when purchasing from an outside supplier. It basically stems
from the fact that suppliers will have priorities other than you if the contract does not allow
for the cost of delay, or a faulty product, would have for you.

Example
Consider a simple example: a restaurant requires its produce and meat to be delivered by
2pm, and the contract it signed with its suppliers states that every hour’s delay will incur a
contractual penalty of $x. Suppose now that the cost of a one-hour delay is $y < $x, but a
two-hour delay would mean that the chef has to rush preparations or even purchase meat
from another source. The cost of delay therefore increases dramatically, and two hours’ delay
means a cost to the chef of $z > $2x. Can this be a problem?

If every restaurant requested delivery at 2pm, it might make sense for the supplier to deliver
orders along the most convenient (and cost-efficient) route – which could mean that our chef
receives the delivery an hour late, which is not a problem as such since the penalty of $x
covers the extra cost of $y and, assuming that the supplier obtains a cost saving of at least $x,
everybody gains from this rescheduling of deliveries. But suppose that an additional hour’s
delay would give the supplier another cost saving (or additional job he can take on) of equal
size (> $x), he would be willing to pay another hour’s penalty, which would send the chef
into a (costly) panic which would not be covered by the additional penalty payment.

In the example above, the problem is that the penalties do not increase according to the real
cost to the restaurant – the key insight is that by purchasing externally, it is important to
realise that the supplier’s incentives will be different to that of any one individual firm.

A similar argument would also be true for the quality of an input. If the incentives to cut
corners for a supplier are not adequately offset by severe enough controls or contractual
penalties, it might lead to a situation where a supplier produces with a higher tolerance for
small imperfections and willingly takes the penalties into account because they are
outweighed by the cost savings achieved.

In the extreme, if the cost of delay, faults and so on are prohibitively high, a supplier might
not even be willing to enter a contract that would adequately reflect these costs. If the risk is

26
too high, a supplier might prefer not to take the risk, and compensating the supplier for it
would be prohibitively costly.

ii) Leakage of Private Information

A firm's private information is information that no one else knows. Private information often
gives a firm an advantage in the market. It may pertain to production knowhow, product
design, or consumer information. When firms use the market to obtain supplies or distribute
products, they risk losing control of valuable private information.

Example
Benetton and Hewlett-Packard (HP) have used the market judiciously because of their
concern over leakage of valuable private information. While Benetton contracts out many
production and distribution activities, it selects dyes and designs and does the actual dyeing
of fabrics in-house. These activities are generally regarded as the source of its advantage in
the market. By keeping them in-house, Benetton has limited competitors' ability to discover
and master its secrets. Until 1995, HP relied on Canon to produce the engines for its laser
printers. When HP and Canon reached this agreement, HP denied Canon access to the PCL
software that differentiates HP printers from those of competitors. Without this access, Canon
has been unable to clone HP's laser printers and has a relatively small presence in the laser
printer market.

As with the coordination problem, firms sometimes rely on contracts to protect themselves
against leakage of critical information. A good example is "noncompete clauses." Many
professionals must sign noncompete clauses when they join a firm.
These clauses state that should the individual leave the firm, he or she may not directly
compete with it for several years. Protected by the noncompete clause, the firm can reveal
important competitive information to its new employees, such as client lists or expert
contacts. Although noncompete clauses are generally effective, in some cases contracts do
not provide much protection.

iii) Transaction Costs

- Spot and Long-term Contracts

Most business relationships are made on the basis of spot contracts—an agreement for
immediate exchange.

A spot contract focuses on a one-time transaction between the buyer and supplier . I sell,
you buy, and that is that. We might, or might not, engage in a similar transaction next week,
or next year.

It is easy to make and cheap to transact. It does not need lengthy negotiation. Nor are
expensive lawyers called to draft their provisions. They are based on standard terms and take
place at market prices. e.g., buying a pack of cigarette or a loaf of bread at Eleven

Spot contracts are effective when individually selfish behaviour works to the best joint
interest of the parties. That is, ‘I have, you want, we exchange.’ We may need to haggle a
little over terms but that is not all.

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Though spot contracts predominate by number in business portfolios they rarely
predominate by value. The most important of commercial relationships are rarely spot
tracts. For example, raising finance, renting property, hiring senior employee, etc.

In such circumstances spot contracts do not perform very well, as they can be susceptible to
opportunistic behaviour from one of the parties in the transaction.

Example: Renting an office space

Tenant’s view

 Once move in, need to make certain commitments to the property. E.g., printing
address, installing telephone or tailor-made decoration.

 Under spot contract, the landlord has a strong bargaining power once the commitment
is made.

 Could promise a low rent then attempt to increase it after the tenant had made a
commitment

 Knowing that this might happen, the tenant would be reluctant to move in at all.

 A formal contract protects the tenant against opportunism by the landlord.

Landlord’s view:

 If the tenant moves out abruptly, the landlord will incur costs, e.g., Agents' fees will
be incurred to find a new tenant and rent lost in the interim,

 By threatening to move out and impose these costs, the tenant might hope to
renegotiate a lower rent.

 A long-term contract protects the landlord against opportunism by the agent and
tenants.

 Whenever there are expenditures, which are specific to the individual buyer or seller,
then there is scope for such opportunistic. Formal contracts reduce such behaviour).

- Problems with Formal contract

To stop opportunistic behaviour, a Formal contract must be Complete.

 A complete contract stipulates each party's responsibilities and rights for each and
every contingency that could conceivably arise during the transaction.

 A complete contract would bind the parties to particular courses of action as the
transaction unfolded.

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  Neither party could exploit weaknesses in the other's position while the transaction
was in progress.

To achieve that
 Parties to the contract must be able to contemplate all relevant contingencies

 The parties must also be able to stipulate what constitutes satisfactory performance
and must be able to measure performance.

 Finally, the contract must be enforceable—an outside party, such as a judge or an

arbitrator, must be able to observe which contingencies occurred and whether each
party took the actions that were required for those contingencies.

Virtually all real-world contracts are incomplete. Why?

 Some of the relevant contingencies cannot be contemplated,

 Some of performance obligation cannot be articulated in those that can be

contemplated.

 Some circumstances under which neither party's rights and responsibilities are clearly
spelled out.

 Incomplete contract give rise to the Asset-specificity and Hold-up problem, together
they define the transaction costs involved in the incomplete contract.

Asset Specificity Problem

An asset is said to be specific if it has significantly less value outside one particular
relationship than it has within it.

 To support the transaction, parties within the contract need to make certain
relationship-specific investment. E.g., special assembly line needs to be installed to
support orders from particular transaction, such as Toyota windscreen.

 However, a relationship-specific asset cannot be redeployed to another transaction,

 e.g., producing windscreens for Honda, without some sacrifice in the productivity of
the asset or some cost in adapting the asset to the new transaction.

 This implies that parties to the transaction cannot costlessly switch trading partners.

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  This is because the assets involved in the original exchange would have to be
reconfigured to be valuable in the new relationship or the investments would have to
be made all over again in the new relationship.

 Investments in relationship-specific assets lock the parties into the relationship to

some degree.
 Example: McDonald's franchisees have to learn the McDonald's system. They must
then buy equipment and fittings are not only specialized to hamburgers but
specialized to that particular burger franchise. If McDonald's wishes to impose new
and onerous demands franchisees, the franchisees ability to resist is much weaker
after they have invested required assets. If franchisees had known what was proposed
they might have preferred to join a different chain or stay out of the burger business
altogether. They might therefore prefer the security of a Classical/Formal contract.

- The Fundamental Transformation

 Before the relationship-specific investments are made, a party may have many
alternatives trading partners, for example, a buyer may be able to choose among
many possible sellers. This allows competitive bidding.

 But after the relationship-specific investments have been sunk, the parties to a
transaction have few, if any, alternative trading partners.

 Competitive bidding is no longer possible.

 In short, once the parties invest in relationship—specific assets, the relationship
changes from a "large numbers" bidding situation to a "small numbers" bargaining
situation. Oliver Williamson refers to this change as the fundamental transformation.

Example:
A real-life example of the fundamental transformation is the relationship between U.S.
automobile assemblers and their component suppliers. Assemblers usually use competitive
bidding for outside suppliers. The assembler solicits bids for short-term (usually one-year)
supply contracts. These contracts specify price, quality (e.g., no fewer than two bad parts per
thousand), and a delivery schedule. Before the contract, there are many potential bidders.
Once the contract is let, however, specific investments on both sides bind the assembler and
supplier in a mutually dependent relationship. For some components, the assembler must
invest in specific production tooling. The supplier must invest in equipment that is tailored to
the assembler's specifications. Because of asset specificity, suppliers and assemblers
understand that suppliers are often bidding not just for a one-year contract, but for a long-
term business relationship.

The fundamental transformation makes the relationship between assemblers and suppliers
contentious. Because suppliers often hope to enter a long-term relationship with an
assembler, they will sometimes bid below cost to win the contract, a strategy known as "buy-
in."

A supplier knows from experience that it might be able to renegotiate with the assembler
based on claims that unanticipated, events (e.g., poorer than expected qualities of key

30
materials) have raised costs. Because changing suppliers at this stage is costly, the assembler
may acquiesce. On the other hand, the assembler's procurement managers are under
tremendous pressure to hold costs down.
At the competitive bidding stage, assemblers will routinely share production drawings with
several potential suppliers. Thus, although it, may be costly for an assembler to replace a
supplier once the component goes into production, it can still do so.

Assemblers do threaten to replace suppliers to hold component prices down. Because a

supplier makes investments that are specific to its relationship with an assembler, termination
of a supply contract can harm it severely. The supplier thus cannot take these threats lightly.
The upshot is that once the fundamental transformation occurs, the relationship between the
assembler and its suppliers often becomes one of distrust and noncooperation. Suppliers are
reluctant to share information on their production operations or their production costs with
the assembler for fear that the assembler will use this information to bargain down the
contract price in subsequent negotiations.

As Womack, Jones, and Roos express it, a supplier's attitude is "what goes on in my factory
is my own business." This greatly impedes the ability of the assembler, and a supplier to
work together to enhance production efficiencies and develop new production technologies.

- Rents and Quasi-Rents

Suppose your company contemplates building a factory to produce cup holders for the Ford
Taurus automobile. The factory can make up to 1 million holders per year, at an average
variable cost of C dollars per unit. You finance the construction of your factory with a
mortgage from a bank that requires an annual payment of I dollars.
The loan payment of I dollars thus represents your cost of investment in this plant . (Note that
this is an unavoidable cost: You have to make your mortgage payment, even if you do not do
business with Ford.—it is sunk)

Your total cost of making 1 million cup holders is thus

(I + 1,000,000C ) dollars per year.

You will design and build the factory specifically to produce cup holders for the Ford Taurus.
Your expectation is that Ford will purchase your holders at a profitable Price P*

It is obvious that 1,000,000(P*- C) > I, in order to give incentive to build the plant but if you
build the factory and do not end up selling cup holders to Ford, you still have a "bail-out"
option:

You can sell the holders to jobbers who, after suitably modifying them, so that they can be
used on other automobiles besides the Ford Taurus, will resell them to other automobile
manufacturers.

The "market price" you can expect to get from these jobbers is Pm. If you sell your cup
holders to jobbers, you would thus get total revenue of 1,000,000P m

Suppose that Pm > C, so the market price covers your variable cost.
* But that the investment cost I > 1,000,000 (Pm – C)

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* Thus, it would not make sense for you to build the cup holder factory if you did not expect
to sell cup holders to Ford.

Relationship-Specific Investment (RSI)

The RSI equals the amount of firm’s investment that cannot be recovered if it does not do
business with Ford.

I - 1,000,000 (Pm – C) represents your company's relationship-specific investment (RSI):

For example, if I = $8,500,000, C = $3, and P m = $4, then the RSI is

$8,500,000 - 1,000,000(4 - 3) = $7,500,000.

Of your $8,500,000 investment cost, you lose $7,500,000 of it if you do not do business with
Ford and sell to jobbers instead.

Rent
Rent is simply the profit the firm expects to get when it builds the plant, assuming all
goes as planned.

Suppose that before you take out the loan to invest in the cup holder plant, Ford agreed to
buy 1 million sets of cup holders per year at a price of P* per unit, where P*> P m
If: 1,000,000(P*- C) > I, should build the plant, then your rent is 1,000,000(P*- C) – I

Quasi-Rent
Suppose, after the factory was built, your deal with Ford fell apart. You can still sell cup
holders to the jobbers. Would you do so when investment cost I > 1,000,000 (P m – C)?

You should sell to the jobbers because 1,000,000(P m – C) > 0, covers your variable costs.

I is a sunk cost and does not affect decision making.

Quasi-rent is the difference between the profit you get from selling to Ford and the profit
you get from your next best option, which is selling to jobbers.
Thus,
[1,000,000(P* - C) – I] – [1,000,000(Pm – C)-I] = 1,000,000(P* - Pm)

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In words: your quasi-rent is the extra profit that you get if the deal goes ahead as planned,
versus the profit you would get if you had to turn to your next best alternative (in our
example, selling to jobbers).

 Rent: Any firm must expect positive rents to induce it to invest in an asset.

 Quasi-rent: it tells us about the possible magnitude of the holdup problem, a problem
that can arise when there are relationship-specific assets.

The Holdup Problem

Anticipating this, Ford could reason as follows. You have already sunk your investment in
the plant. Even though Ford "promised" to pay you P* per cup holder, knows that you would
accept any amount greater than Pm per unit and still sell it.

Thus, Ford could break the ‘promise’ and offer you a price between P* and P m;

Didn't Ford sign a contract with you? Virtually all the contract is incomplete, Ford could
assert that

- Circumstances have changed and that it is justified breaking the contract.

- Increases in the costs producing the Taurus will force it to discontinue the model
unless suppliers renegotiate their contracts.

By reneging on the original contract, Ford has "held you up" and has "transferred" some of
your quasi-rent to itself.

P* = $12 per unit, Pm = $4 per unit, C = $3 per unit, and I=$8,500,000.

At the original expected price of $12/unit, your rent is

(12 - 3)1,000,000 -8,500,000 = $500,000

Your quasi-rent is (12 - 4)1,000,000 = $8,000,000

If Ford "renegotiates" the contract down to $8 per unit, Ford will increase its profits by $4
million per year and it will have transferred half of your quasi-rents to itself.

After the holdup has occurred, you get a profit of

(8 - 3)1,000,000 - 8,500,000 = -$3,500,000

- This tells us that if, instead of trusting Ford, you had anticipated the prospect of
holdup, then you would not have made the investment in the factory to begin with.

- If an asset was not relationship-specific, the associated quasi-rent would be zero.

- When a firm invests in a relationship-specific asset, the quasi-rent must be positive.

33
 - It will always get more from its best alternative than from its second-best alternative.

- If the quasi-rent is large, a firm stands to lose a lot if it has to turn to its second-best
alternative.

This opens the possibility that its trading partner could exploit this large quasi-rent, through
holdup.

A firm holds up its trading partner by attempting to renegotiate the terms of a deal.
A firm can profit by holding up its trading partner when contracts are incomplete (thereby
permitting breach) and when the deal generates quasi-rents for its trading partner.

An Analytical Illustration of the Holdup Problem

There are two players, a buyer and a seller and two dates 1 and 2. At date 1, the seller
chooses an investment level I > 0.

At date 2, the seller may sell the good to the buyer (whose valuation for the good is v>0) and
the seller has a cost c(I) of supplying it.

Seller can only sell the particular good to the specific buyer, there is no alternative.
There is no discount.

A) Suppose at date 2 the buyer observes the investment I and makes a take it or leave it offer
to the seller. What is this offer? What is the subgame perfect equilibrium of the game?

Solution
We can set the timing of the game in the first formulation as follows:

- t = 1, the seller makes an investment I > 0,

- t = 2a, the buyer observes I and makes a take it or leave it offer at price P to the seller,

- t = 2b, the seller may reject the offer and the game ends or the seller can accept the
offer and deliver the good at costs c(I).

Backward Induction:

- After the buyer offers a price P, the seller sells if c(I) < = P.

- Knowing this, at t = 2b, the buyer offers P = c(I).

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 - At t = 1, the seller knows that future prices are P = c(I) for any level I of investment
chosen. The profits is thus [c(I) - I - c(I)] = -I.

- Clearly, the maximising choice for the seller is I = 0.

This is the 'hold up' problem where the seller fears that investment will lead to an unfair deal
in the bargaining (in stage 2) since the investment costs have already been sunk. Fearing this,
he refuses to invest.

B) If there is a date 0 (before date 1 and 2) where a contract (with no breaching possibility,
i.e., Complete Contract) over future price could be signed between the buyer and the seller
and the only decision at date 2 is the seller deciding whether to deliver the good at the
contracted price, then can we have a contract which can solve the inefficiency problem of
(a)?

Solution:
- t = 0, the seller and the buyer signs a contract which promises a price P

- t = 1, the seller makes an investment I > = 0, if the price P is agreed at t=0

- t = 2, the seller decides whether to deliver the good or not at the contracted price P; if
he delivers, he incurs a further cost of c(I).

Backward Induction:
- At t = 2, the seller will deliver the good at any price P > c(I).

- At date t = 1, the seller looks at the following maximisation problem:

MaxI P - c(I) - I

If these maximised profits are greater than equal to zero (this implies P > c(I)), then the
seller goes for the required investment level I* which from first order conditions satisfies 1 +
c'(I*) = 0.

If the profits are less than zero, he selects zero investment level.
At t = 0, any price P satisfying P - c(I*) - I* > = 0 and v >= P will ensure an efficient level of
investment regardless of how the surplus is distributed between the seller and the buyer. The
'hold up' problem has been solved.

Example: Hold up problems abound in the computer industry.

Intel has been one of the most powerful and innovative semiconductor manufacturers ever
since it was founded in 1968. Buyers of semiconductors design their products around the
functions performed by a particular supplier's semiconductors.

In the process they get locked into that design and have to incur large setup costs.

35
Switching to a new semiconductor chip becomes very expensive for a buyer and there are
few alternative sources for the original chip. So buyers do not want to buy semiconductor
chips from a manufacturer with a specialised design.

As an interesting solution to the holdup problem, Intel followed an aggressive licensing

policy. Other semiconductor manufacturers could use Intel's semiconductor designs for a
license fee and produce the same semiconductors. This removed the alternative sources
scarcity problem for buyers and they were more willing to buy Intel's design.

Exercises
In USA in the late 1980s, the 'existing' franchises of Taco Bell were paying Taco Bell a
royalty based on a percentage of sales revenues. These franchises did not have any exclusive
territory' (ensuring that the franchisee is a local monopoly) clauses in the contracts. Around
this time, Taco Bell pursued a growth strategy to make its market presence comparable to
Macdonald's. It franchised a large number of new outlets all over USA and also introduced
Taco Bell Express, concession stands that offered a limited menu of its food. The existing
franchisees were threatened with additional competition. They strongly opposed this strategy
with little success.

Explain the nature of the holdup problem. Why did the existing franchisees not threaten to
terminate their relationship with Taco Bell? Could they have done any better when the
original franchise contracts were being drafted?

To summarize, the term transaction costs define those costs arising from an exchange
relationship – which could be governed by a written contract or an implicit or relational
contract. There are direct costs and indirect costs. Indirect costs may often affect the value of
a transaction more significantly than direct ones.

Direct costs are the time spent on specifying a contract, lawyers’ fees for drawing up the
contract, writing job descriptions and so on. Most often, these will be much lower within the
firm than on the market – predominantly because a contract need not be written.

Another direct cost would arise from monitoring the quality of the exchanged product and
from the cost of faulty items – if someone has to spend time and effort removing faulty
products that the other party has delivered and if this screening process is not perfect, costs
arise from completing this specific transaction.

Indirect costs are more difficult to quantify, but they often have more bearing on the decision
to make or buy – if indirect transaction costs are too high, ‘it’s just not worth the effort’.
Indirect costs mainly arise from the fact that contracts are incomplete in the sense that they
do not specify precisely what should happen (or what both parties are obliged to do) for any
possible contingency in the market. If a situation arises that has not been specified in the
initial contract this is then subject to haggling and negotiations, and the expected losses from
the partners behaving opportunistically.

Both parties will have to take into account that incentives are not perfectly aligned and that
the other party will try to maximise its own pay-offs if the finer points of the contract allows.

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Insurance for many types of natural disasters are subject to large uncertainties in the
determination of damages and payouts. For example, Hurricane Katrina had (and still has)
insurance companies and insured parties in bitter fights because many policies exclude water
damage, but include wind damage – it is now a matter of interpretation if the damage to
property has been caused by the severe winds or tidal waves – and naturally both parties
claim the outcome most favourable to them, which is surely going to generate a significant
revenue stream for the legal profession. Generally, indirect transaction costs are higher in
market transactions because the incentives are less aligned than within the firm.

This implies that if a contract cannot be specified well so that a large (and costly) number of
contingencies cannot be catered for, relationships are likely to be within one firm. Both
elements of transaction costs are important – for example, it is easy to imagine that a
homeowner expecting to incur huge legal costs to secure a payout following a natural disaster
will decide not to take out insurance despite the direct transaction cost being relatively small,
with a standard contract being offered over the phone, for example.

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