Week 4: Integration and Its

Alternatives & Competition I

Dr. Xu Le
Course Outline
• The property right theory of the firm

• The technical efficiency /agency efficiency trade-off

• Alternatives to vertical integration

• Tapered integration
• Franchising
• Strategic alliances and joint ventures.

• Identifying competitors
Part I. Integration and Its
Alternatives
Vertical Integration and Asset Ownership
• With complete contracts it does not matter who owned
the assets in the vertical chain.
• With incomplete contracts, ownership determines the
willingness of each party to make relationship-specific
investments.
Asset Ownership and Integration
• Asset ownership is an important dimension of vertical
integration
• There could be degrees of integration depending on the
extent of control over specialized assets
• Example: Auto manufacturers can use independent
suppliers for body parts but own the dies and stamping
machines
 In 2020, Sea Group’s e-commerce
firm Shopee set a new record of
selling 200 million items in 24 hours,
up 186% from last year’s 70 million
products, while Alibaba-backed
Lazada said it hit USD 100 million in
transactions “in less than half the
time” compared to 2019.

Ninja Van counts Lazada, Shopee, Tokopedia, Zalora, and Bukalapak as its e-
commerce partners.

Source: https://kr-asia.com/southeast-asias-e-commerce-boom-fuels-the-surging-logistics-demand-qa-with-ninja-van-ceo-and-coo
 Singpost and Alibaba set up
joint venture to enhance e-
commerce logistics
capabilities in Southeast Asia
and Oceania.
Source: https://asia.nikkei.com/Business/Alibaba-and-SingPost-
show-their-ambitions-in-Asia-and-beyond

Amazon delivered 72% of

its own packages in Sep
2021, compared with 54% in
July 2019
Source: https://www.cnbc.com/2021/09/04/how-amazon-is-
shipping-for-third-parties-to-compete-with-fedex-and-ups.html
Vertical Integration and Asset Ownership
• Three ways to organize the vertical chain
• The two units are independent (non integration)
• Upstream unit owns the assets of the downstream
unit (forward integration)
• Downstream unit owns the assets of the upstream
unit (backward integration)
Backward Integration: Tata Steel’s
Acquisition of Labrador Iron Mines
Forward Integration: Amazon’s Acquisition of
Whole Foods

The company’s $13.7 billion

deal for Whole Foods is the
latest signal of Amazon’s
ambitions to have a hold on
nearly every facet our lives —
like the computer servers that
power our favorite websites
and the food we eat.
Amazon vs. Alibaba: Tradeoff in Business
Models
Tesla’s Direct Sales
Discussion Question
Under what conditions, vertical integration is desirable?
Two Costs and Two Efficiencies
• Using the market improves technical efficiency (least
cost production)
• Vertical integration improves agency efficiency
(coordination, transactions costs)
• Firms should “economize” - choose the best possible
combination of technical and agency efficiencies.
Agency cost (A)
• When the item is purchased from an outside supplier,
these costs comprise
• The direct costs of negotiating the exchange;
• The cost of writing and enforcing contracts;
• The costs associated with holdup and under-investments in
relationship-specific assets.
• The cost of breakdowns in coordination and leakage of
private information.
• When the item is produced internally, these costs include
• The agency
• The influence costs.
Technical and Agency Efficiency

• The curve DT depicts the differences in technical

efficiency. It measures the differences in production
costs when the item is produced in a vertically
integrated firm and when it is exchanged through an
arm’s-length market transaction.

• DA measures differences in exchange costs when the

item is produced internally and when it is purchased
from an outside supplier in an arm’s-length
transaction.

Tradeoff between Agency Efficiency and Technical Efficiency

Question
• With an increase in scale, what will happen to the
differential agency efficiency/technical efficiency?
Alternatives to Vertical Integration
• Tapered integration (making some and buying the rest)
• Franchising
• Joint ventures and strategic alliances
Tapered Integration
• Tapered integration is a mixture of vertical integration
and market exchange.
• A firm may produce part of its input on its own and
purchase the rest.
• A firm may sell part of its output through in-house sales
efforts and sell the rest through independent distributors.
Where to Buy a MacBook?
Tapered Integration: Advantages
• Additional input/output channels without massive capital
investments.
• Information about costs and profitability from internal
operations can help in negotiating with market firms.
• Threat of self-manufacture can impose discipline on
external suppliers.
• Internal channels will be motivated by potential expansion
of the use of outside sources.
• Internal supply capabilities will protect against potential
holdups
Franchise
• Franchising allows small-business owners to grow
rapidly.
• Franchisees put up the capital to build and operate their
stores and pay a fee for the right to use the franchiser’s
name and business model. Franchisers may also require
franchisees to purchase from designated suppliers, offer
specific products, and conform to architectural and
design guidelines.
Strategic Alliances and Joint Ventures
• Strategic alliances involve cooperation, coordination
and information sharing for a joint project by the
participating firms.
• A joint venture is an alliance where a new
independent organization is created and jointly owned
by the promoting firms.
Barnes & Noble vs. Starbucks
Joint Ventures as a special form of
Strategic Alliance

Grab Holdings Inc.'s joint venture with Singtel is planning to hire

200 people before the digital bank's expected launch in early 2022.
Strategic Alliances
• Strategic alliances and joint ventures fall between pure
market exchange and full vertical integration.
• Alliances rely on trust and reciprocity instead of contracts.
• Disputes are rarely litigated but resolves through negotiation.
Strategic Alliance - Scenarios
• Uncertainty surrounding future activities prevents the
parties from writing detailed contracts.
• Transactions are complex and one cannot count on
contract law to “fill the gaps.”
• Relationship-specific assets give rise to potential holdup
problems.
Part II. Competitors and
Competition I
Are US Airlines profitable?

https://www.youtube.com/watch?v=Mj8WZLtqo7Q
 The Brief U.S. Airline Industry
• The 1990s began with a mild recession that left carriers with empty
seats. (Strategy: price slash; Result: huge loss exceeding $4 billion in
1992)
• In the mid-1990s, the economic recovery lifted the industry.(Strategy:
price rise and computerized pricing algorithm Result: earning a
combined $4 billion in 1999)
• In 2000 and 2001, economy softened and September 11 attack
threaten many major airlines. (Strategy: government bail-out)
• In the mid-2000s, economy revived, and the airlines filled their
planes, raised their prices.
• In the late 2000s, the great recession triggered another decline in
demand.(Strategy: capacity cut, and mergers to reduce competitors
Result: U.S. airlines turned a healthy profit in 2010.)
Competition
• If one firm’s strategic choice adversely affects the
performance of another they are competitors.
• A firm may have competitors in several input markets and
output markets at the same time.
• Input Market: The markets in which the resources used to produce products are
exchanged.
• Output Market: The markets in which goods and services are exchanged.
• Competition can be either direct or indirect.
Direct and Indirect Competitors
• Direct competitors: Strategic choice of one firm directly
affects the performance of the other.

• Indirect competitors: Strategic choice of one firm affects the

performance of the other because of a strategic reaction by a
third firm.
Examples

Direct Competitors

Indirect Competitors
Any other way to identify competitors?