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Vertical integration

When does outsourcing/ownership matter?

What is vertical integration?  

Vertical (or horizontal) integration means that the assets that were previously held by two firms are combined into a single firm. The result is either joint ownership or the sale of one firm¶s assets to the other.

Market Imperfections 

Upstream and downstream firm Downstream firm 

Monopolist with no costs Sets price to its market (mark-up over marginal costs) Monopolist Sets input price to downstream firm anticipating impact on demand 

Upstream firm 

Vertical Integration   

Suppose upstream and downstream firms are commonly owned Best internal transfer price is based on upstream marginal cost, c. Market price set so that MR = c. Maximises joint profits

Impact on Profits

PS PI c+t
Downstream Profit Upstream Profit

Downstream Marginal Cost Joint Marginal Cost Demand

c Marginal Revenue QS QI

Double Marginalisation 

With outsourcing 

Both firms charge a mark-up Higher prices, low overall profits, lower consumer welfare (not very competitive if there is another vertical chain) Vertical integration Two-part tariffs More downstream or upstream competition 

Solved by: 

Can vertical integration matter? 

The Coase Theorem tells us that asset ownership does not matter for efficiency. 

Assumes complete contracting 

When contracts are incomplete there exist residual rights of control (unspecified actions). According to Grossman & Hart:
³To the extent that there are benefits of control, there will always be potential costs associated with removing control (i.e., ownership) from those who manage productive activities.´

GM-Fisher Body  

1920s: General Motors purchased car bodies from independent firm (Fisher Body) Technology change: wooden to metal GM built a new assembly plant that required reliable supply 

wanted Fisher Body to build a new car body plant next to it no need for shipping docks etc.

Fisher Refused 

Fisher Body refused to make this investment. Feared that a plant so closely tailored to GM¶s needs would be vulnerable to GM¶s demands (hold-up) Eventually resolved this issue by vertical integration -- could not find a contractual solution

Merger Benefits & Costs 

Benefits to GM: 

Could make more demands of Fisher Body More investment or extra supply Diminished managerial incentives If costs are lowered in the body plant, GM is better able to appropriate these at expense of managers. Harder to keep those costs down. 

Costs to GM: 

Bottling Pepsi 

PepsiCo has two types of bottlers:  

Independent: owns assets of bottling operation and exclusive rights to franchise territory. Can determine how these are used - when to restock stores etc. Company owned: decisions can be made higher up; Pepsi can choose to delegate local marketing to its subsiduary

Pepsi¶s Control 

Pepsi cannot control how an independent bottler operates in a territory 

If it wants a national marketing strategy (such as the Pepsi Challenge), it can¶t compel the bottler to cooperate If the subsidiary managers refused to participate in the national campaign, they could be sacked and replaced. 

By acquiring a bottler, Pepsi has ultimate control. 

Motivating Example Again 

Service requires a truck (the asset) for production Also, enhancing value are:  a shipper, S (who wants to ship goods) 

there are also other shippers except that they have goods to ship that are $100 less in value created 

a trucker, T (does this): can take care or no care in maintaining truck; 

there are many truckers who can take no care but this particular trucker is the only one that can take care 

Effort in care is relationship-specific and is now assumed to be non-contractible Also assume that care is a skill that is developed (through habits etc.). Therefore, it becomes embedded in the trucker¶s human capital.

Effort and Value 

Benefit from extended truck life 

No Care: truck¶s value is $50 Care: truck¶s value is $200 Minimal care: cost of $0 High care: cost of $100 Efficient to take care 

Trucker¶s effort cost of care 

Marginal Benefit = $150 > $100 = Marginal Cost 

What happens under different ownership structures for the asset?

Non-contractible Investment  

Suppose bargaining took place after effort choice is made There are four cases to evaluate. 

Minimal care and alternative shipper Minimal care and S High care and alternative shipper High care and S 

S is no longer essential and so their added value is less than the T if they do not own the asset.

Will trucker take care?
Ex Post Added Values: Ho to Share $200
Ownership Structure Shipper·s Added Value (Expected Surplus) $200 ($125) $100 ($50) $200 ($100) $100 ($16.66) Trucker·s Added Value (Expected Surplus $150 ($75) $200 ($150) $200 ($100) $150 ($66.66) 3rd Party·s Added Value (Expected Surplus) $0 ($0) $0 ($0) $0 ($0) $200 ($116.66)

Backward Integration Forward Integration Cooperative Vertical Separation

Incentives and Ownership  

Trucker can be easily replaced if does not take care. However, under BI and 3rd party ownership (vertical separation), does not expect to earn enough to cover costs of $100. Will take care under FI: needs to have control rights (i.e., right to exclude use of asset) in order to gain sufficient surplus ex post. 

That is, under FI, by taking care, T gets $50 (=$150-$100) but only $25 if it does not take care. Under Cooperative, taking care gives T $0 but not taking care gives them $25. 

General principle: give control rights to agents making important investments.

Efficient Integration Level  

As they encourage the trucker to take care, forward integration is the only efficient organisational form Do we expect asset ownership to track efficiency?

Shipper Interests  

Shipper might choose to have a back haul. A back haul adds value of $100 (independent of level of care). Suppose that trucker ± if they own the truck ± can find alternative customers for the back haul. If expend cost of $10 will find alternative customer adding value of $50.

Forward Integration 

Shipper¶s added value ex post: 

$250 if trucker searches for alternative customer $300 if trucker does not search $300 regardless of whether searches Searching improves trucker¶s expected surplus from $150 to $175; therefore, worth the $10 expense. 

Trucker¶s added value ex post 

If search very costly, BI may become efficient again.

Optimal Firm Boundaries 

Ownership provides maximal incentives to take non-contractible actions Optimal firm boundary depends upon: 

whose actions are hardest to encourage whose actions are most important for value 

Never vest ownership with someone who does not provide a non-contractible action (I.e., 3rd party)

What Happens in Trucking? 

Suppose that you could put on-board computers on truckers to monitor drivers. Theory: easier to monitor driver¶s care and reflect it in explicit performance payments or fines ± therefore, less need for trucker ownership. Baker & Hubbard (2000): use of OBCs has increased non-trucker ownership especially on routes that may be more subject to trucker rent seeking.

Shipper vs. Carrier ownership  



What determines whether shippers use internal (captive) fleets or for-hire carriers for a haul?  Determines who owns control rights associated with dispatch (truck scheduling) Shippers use internal fleets when want high service levels from truck drivers Truck utilisation higher in for-hire fleets ± ability to line up a sequence of hauls for a truck ± tight coordination (requires dispatcher effort) Need for flexibility conflicts with search for back hauls Harder to motivate truck drivers when looking for high service levels. Empirically: OBCs lead to more shipper ownership

Case: Insurance Industry 

Insurance industries 

In-house sales force: whole life Independent brokers: fire and casualty 

Choice determines ownership of client list

Effect of ownership 

Agent owns list 

cannot be solicited without permission agent looks for clients most likely to renew motivate agents by using renewal commission agent can hold-up company; threaten not to introduce new products to clients company can hold-up agent; threaten to increase premiums that reduce renewal commission 

Company owns list 

Applying Grossman & Hart 

Choice between independent and in-house agents should turn on relative importance of investments in developing long-term clients by the agent and listbuilding activities of the insurance firm 

Whole life: customer less likely to switch so searching for long-term customers less important -- in-house Fire & casualty: searching for long-term customers is important -- independent

Dynamic Issues
How does outsourcing and integration performance change over time?

T5 at Heathrow 

Project management handled internally Contractors on cost-plus contracts (not fixed price as is usually the case) British Airports Authority wanted to keep options open to change design specifications throughout the life of the project Happy to engage in on-going managerial attention

Fixed vs Cost Plus   

Fixed contracts  Costs aren¶t passed through  High powered incentives to keep costs down  Anticipate cost savings that might be achieved when tendering  But contracts incomplete: so subject to renegotiation (also anticipated in tender) Cost plus contracts  Costs are passed through  Low powered incentives  No difficult renegotiations ± easier to change designs during project For complex projects that require lots of coordination, may be better to use cost plus contracts

Car Manufacturing 

Varied patterns of outsourcing 

Some companies integrated (GM) Some outsource almost everything (Volvo)
External sourcing allows firms to access state-of-the-art technology but leaves them open to hold-up and low effort supply after the initial terms of the contract are satisfied Internal development is associated with inferior technology development and high costs for an initial model-year, but there are much greater opportunities for improvements over time 

Novak-Stern case studies suggest that...  

Performance Over time
Vertical Integration
Deep vehicle- specific knowledge base  Less knowledge of system-specific technology  Difficult to enforce specific performance criterion 

External Sourcing
supply opportunities  Opportunity for welldefined performance contracts 

Ex Ante Contracting Opportunities

Ex Post Renegotiation Outcomes

Continuing authority relationship allows for redirection  Potential for learning 

Hard to enforce contracts after key requirements have been met  Fewer continuing relationships 

Empirical Findings
Performance (Consumer Reports) Internal Sourcing


Model Year


No black and white choice in outsourcing Capabilities can improve over time 

Ability to coordinate internal or external teams Ability to improve internal performance Handling contractual disputes Complexity ± design and parts 

No µone size fits all¶ 

Principles of Efficient Ownership   

Simple example  Asset: luxury yacht  Service: gourmet seafare  Workers: chef and skipper  Customer: tycoon Value created  Tycoon value = $240 (no other customers)  Substitutes for skipper¶s skills (no added value)  Chef: asset-specific action (no other yachts) for cost of $100; necessary to provide service for Tycoon Time-line  Date 0: chef chooses whether to take action  Date 1: negotiate over division of $240

Ownership Outcomes
Owner Skipper Tycoon Chef

Division (S, T, C) Invest

240/3 each

0, 240/2, 240/2

0, 240/2, 240/2




Skipper Value 

Now suppose, skipper has a non-contractible (date 0) action  

for cost of $100 can increase value of service to tycoon by another $240 (total now $480) for example, increases knowledge of local islands

Ownership Outcomes
Owner ki er yc n Chef

ivisi n ( , , C) Invest






8 ,




Complementary Assets 

Now suppose there are other customers who can use the yacht But tycoon can choose a non-contractible action (e.g., plan entertainment schedule for the year). Gives additional value of $240. Yacht can be split in two: galley and hull

Divided Ownership 

Is it ever optimal for chef to own galley and skipper to own hull? 

Division of value is: chef ($320), skipper ($320) and tycoon ($240/3) Tycoon has to reach agreement with both while skipper and chef only require their joint agreement 

Better to give entire yacht to skipper or chef. Tycoon¶s incentive rises ($240/2)


Never give ownership to dispensable individuals Give ownership to indispensable agents (even though may not make an investment) Vest ownership of complementary assets with a single individual


Does asset ownership really improve incentives for specific investments? 

Those investments create value But may reduce the asset¶s value outside of the relationship: it is specialised to the other agent Without ownership, do not care about this reduction Hence, it is possible that incentives could be reduced by ownership


Value of ownership 

Increased bargaining position (added value) Ownership improves this by allowing agent to capture a greater share of the rewards But diminishes the incentives of non-owners Agents taking non-contractible actions Important agents 

Incentives to take non-contractible actions   

Who should own an asset?