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Outline the theories suggesting the determination of firms’ boundaries. Discuss these with reference to at least two examples of firms, either historical or present-day
Strategy can be understood in terms of what comprises of a firms’ boundaries. The boundaries of a firm can be defined beneath two categories; those consisting of a horizontal nature as well as those which are vertical. Before exploring these boundaries from the perspective of theories, an understanding of their meaning is crucial. Horizontal boundaries refers to the size of a firm, in terms of what it produces, at what scale and the extent to which it specialises in particular products; being either one or several. Vertical boundaries are those which encompass the amount of the vertical supply chain that a firm produces itself. A firm faces the decision of manufacturing the products themselves verses purchasing this service from elsewhere. In this essay I would like to explore these boundaries from the perspectives of Williamson’s transaction cost theory and Michael Porter’s concept of strategy. The transaction cost theory became most widely recognized through Oliver Williamson’s book ‘The Economics of Transaction Costs’ (Williamson, 1999) after the theory was originally proposed by Ronald Coase. It states that a transaction cost can be any outlay that is occurred in exchanging the right of use of a good or service from one individual or institution to another. This can include more than purely the day-today fee associated with buying and selling. An example could be a cost incurred with ensuring a contract is successfully accepted such as costs for gathering information as well as informal gifts. The theory is based on two assumptions; bounded rationality and opportunism. The first of these denotes the idea that human beings have limited ability to deal with more than a small amount of possibilities and as a result poor foresight may occur. Our capacity of processing knowledge in this case is limited. The latter states that human action is self-interested meaning individuals will take advantage of situations in pursuit of personal gain. Transaction cost theory would seem to have greater importance for vertical boundaries rather than horizontal, yet is still applicable for both. Referring back to the definition, horizontal boundaries of a firm encompasses the way in which a firm decides to specialise in products or services. A firm may decide to remain focused on its core activities, but alternatively could progress into new markets offering products or services which are considerably different from those originally offered. In the book ‘Hallmark: A Century of Caring’, diversification is accredited to much of the enormous growth of the American firm (Regan, 2009; 186). Hallmark had humble beginnings of postcard sales from a shoebox, and is now the largest manufacturer of greeting cards in the United States.

Over its century long history, Hallmark has diversified into selling wrapping paper, crayons, markers, toys and also has its own television network; proving this strategy has influenced their success. Accompanying the transaction cost theory are economies of scope. This involves the sharing of managerial talents, knowledge and experience that can be shared throughout similar sectors of a conglomerate firm (Douma et al, 2008; 226). Economies of scope can be obtained through an enlarging of horizontal boundaries in order to reduce transaction costs. Michael Polanyi makes a valuable point however, with his notion of tacit knowledge (Polanyi, 1966). This consists of the idea that information and expertise which is not easily written down can be hard to explain and transfer, consequentially economies of scope may be less achievable than first thought. Porter’s five forces model most certainly coincides with the features of horizontal boundaries (Porter 1979, p.137). The existing competitive rivalry within an industry can be affected by a firm’s desire to diversify into new niches of the market. As more firms specialise in a greater array of products and services, the competition will naturally increase creating additional pressure on those already existing in the particular market position. Additional entry barriers will be created when high value firms enter, also reducing one of Porter’s forces, the threat of new entrants. Porter highlights that sustainable competitive advantage is essential for a firm’s continual survival (Porter, 1990). Innovation in his eyes is vital. However Porter also agrees there is a danger in employing broad strategy, ‘The worst strategic error is to be stuck in the middle, or to try simultaneously to pursue all the strategies…pursuing all strategies simultaneously means that a firm is not able to achieve any of them because of their inherent contradictions’ (Porter, 1990; 40). Diversifying can bring a weakness in corporate strategy. Moreover there may in fact be great strength in enduring in one specialised strategy. Jermyn Street in London is famous for its bespoke tailors and finest quality shirts and suits. Diversifying further into products other than clothing could hinder the future success of such traditional firms, and so they remain persistent, working for greater feat within their original sector. It would appear the expansion of horizontal boundaries is perhaps not right for every firm; some may pursue an increased specialisation in product range yet others remain content, still challenged within their singular focus. The vertical boundaries of a firm however, ‘means moving into the production of previous stages (backward integration) or subsequent stages (forward integration)’ (Douma et al, 2008; 222). The supply chain includes all aspects and transactions that are made from the beginning of production, such as obtaining and using raw materials, to the final stage of retail where the finished products are purchased and used by customers. Within the vertical supply chain the question whether to produce products oneself or to purchase the service from

elsewhere remains highly important to a firm. Research conducted by Kirk Monteverde and David Teece examines the make or buy decisions of Ford and GM. They discovered that it would be most probable for the car makers to ‘produce components that required significant amounts of applications engineering effort and more likely to buy components that required small amounts of applications engineering effort’ (Besanko et al, 2010; 156). These two multinational car manufacturers have discovered the benefits of both taking on production them self and also purchasing this service from alternative methods, depending on the specialisation needed; enter asset specificity. Asset specificity is the extent to which the investments made to support a particular transaction have a greater value to that contract than they would have had they been redeployed for a different purpose (McGuinness, 1994). Transaction costs are directly linked with this decision. Shell Petroleum is a great example of a highly vertically integrated firm as they are involved in searching for oil, drilling for wells, extracting and transporting the oil; refining it into petrol and diesel, and finally selling the fuel in its petrol stations (Alchian, 1978). Through a greater control of the vertical chain a firm can profit from economies of scale, which is the saving on each unit of production through manufacturing large volumes, resulting in huge savings. Owning the entire supply chain also may result in increased privacy, protecting innovative ideas, improved communication, as all stages are conducted in-house and the hold-up problem can be avoided. This problem is the lack in communication in contractual agreements, resulting in time delay, a possible change of existing planning and bounded rationality, meaning incomplete information, spoken briefly of earlier. Opportunism of suppliers and other partnerships may in addition be eliminated, though full control over the entire supply chain. Once more Porter’s five forces model demonstrates its relevance, this time showing how vertical integration can reduce opportunism, by limiting the bargaining power of supplier as a vertically integrated firm would simply be their own supplier. Similar to this model Michael Porter’s value chain analysis is a tool for diagnosing and sustaining competitive advantage (Porter, 1985; 37). It also provides assistance in designing organisational structure through analysing the firm’s core activities. The majority of organisations are part of a wider system of adding value involving supplier and distributor channels. With high vertical integration come many newly created operational segments each with its own purpose. Furthermore, it is the linkages between these different activities that are important to be coordinated and ensure these fall under the firms overall competitive position, which is accentuated in the value chain analysis. Discussed in ‘Economics of Strategy’ the internet service provider AOL is chosen as an example of vertical integration. In 2000 the firm,

combined with Time Warner, decided to obtain a new girl band called Eden’s Crush. The first album released was not at all lucrative and compared to another group called O-Town, who worked instead with several independent companies, AOL Time Warner finished well behind in sales alone (Besanko et all, 2010; 119). Emphasised here is an example of vertical integration falling short when compared with traditional independent supply chain methods. Concluding, the choices involved with both horizontal and vertical boundaries of a firm largely influence its success. Assuming tacit knowledge can be overcome; horizontal diversification has the potential of bringing economies of scope, yet a firm’s overall strategy may deteriorate as a result of an ever-increasing product base. Often a firm’s strength may be found in its ability to specialise in one particular product or service, suggesting expanding horizontally in this case may prove to be costly. If nevertheless expansion in this direction is necessary, a coalition which is a ‘long-term agreement among firms that go beyond normal market transactions but fall short of outright mergers’ (Porter, 1990; 57) may well be beneficial. Vertical integration most certainly permits a reduction in transaction costs, provided the firm has enough specificity to perform that particular part of the supply chain. Outsourcing has recently become more popular especially through the use of eastern companies providing large savings on labour in particular, and so could be offered as an appropriate alternative. ‘The very essence of capabilities/competences is that they cannot be readily assembled through markets’ (Teece et al, 1994). If this difficulty can be conquered through ensuring consistent quality and asset specificity, then outsourcing can be viewed as a viable substitute. In closing, a combination of adopting both means of horizontal and vertical growth may well be the solution. Ample research is of course necessary before any firm decides to expand in either direction, being that each firm will have different overall strategies. Above all discernment is essential.

Bibliography Alchian, A. et al (1978) Vertical Integration, Appropriable Rents, and the Competitive Contracting Process Source: Journal of Law and Economics, Volume 21 Besanko, D. et al (2010) Economics of Strategy, 5th Edition, Asia: John Wiley & Sons Pte Ltd Douma, Shreuder (2008) Economic Contributions to Strategic Management, in Economic Approaches to Organisations, Prentice Hall McGuinness, T. (1994) Markets and Managerial Hierarchies, in G. Thompson, et al. (Eds.), Markets, Hierarchies and Networks, London, England: Sage Polanyi, M. (1966) The Tacit Dimension, Garden City, New York: Doubleday & Company Inc Porter, M. E. (1979) How Competitive Forces Shape Strategy, Harvard Business Review Porter, M.E. (1985) Competitive Advantage: Creating and Sustaining Superior Performance NY Free Press Porter M.E. (1990) The Competitive Advantage of Firms in Global Industries, Chapter 2, London: Macmillan Regan, P. (2009) Hallmark: A century of Caring Teece, D., Pisano, G. (1994) The Dynamic Capabilities of Firms: an Introduction, Volume 3, The Oxford Press Williamson, O. E. (1999) The Economics of Transaction Costs: E. Elgar Publishing