The Vertical Boundaries of the FirmThe Vertical Boundaries of the Firm

(Organization of Economic(Organization of Economic Activity Activity)

Chapter 3Chapter 3

-Raw Inputs(trees, Iron, cows etc.)

-Transportation

-Intermediate Goods Processing(lumber milling, frame fabrication)

-Transportation and Warehousing

-Assemblers(furniture manufacture)

-Transportation and Warehousing

-Retailers (furniture stores)

The Vertical Chain of Production for FurnitureThe Vertical Chain of Production for Furniture

Processing and HandlingProcessing and Handling

Accounting

Finance

Human Resource Management

Legal Support

Marketing

Planning

Other Support Services

Support ServicesSupport Services

In-Bound Logistics

Manufacturing Operations

Outbound Logistics

Marketing and Sales

Customer Service

Value-added

Value-added

Value-added

Value-added

The Value ChainThe Value Chain

Procurement

Technology Development

Human Resource Management

Infrastructure Activities

Primary ActivitiesPrimary Activities

Support ActivitiesSupport Activities

The Make versus Buy Decision The Make versus Buy Decision

Upstream-DownstreamUpstream-Downstream

Make or Buy ContinuumMake or Buy Continuum

Arm’s Length Arm’s Length TransactionTransaction

Long-Term Long-Term ContractsContracts

Strategic Alliances Strategic Alliances and Joint Ventureand Joint Venture

Parent/SubsidiaryParent/Subsidiary RelationshipsRelationships

Perform Activity Perform Activity InternallyInternally

Less IntegratedLess Integrated More IntegratedMore Integrated

Benefits of Using the MarketBenefits of Using the Market

Efficiencies resulting from competitive marketEfficiencies resulting from competitive marketdynamicsdynamics

Market firms can achieve economies of scaleMarket firms can achieve economies of scale

Use of specialized or proprietary technologiesUse of specialized or proprietary technologies

MES versus organizational requirementsMES versus organizational requirements

Intangible benefitsIntangible benefits

Avoidance of agency and influence costsAvoidance of agency and influence costs

Costs of Using the MarketCosts of Using the Market

Poor coordination in the value chainPoor coordination in the value chain

Reluctance of trading partners to share valuableReluctance of trading partners to share valuableinformationinformation

Transaction CostsTransaction Costs

Coordination of Production Flows ThroughCoordination of Production Flows Through the Vertical Chainthe Vertical Chain

Coordination is especially important when designCoordination is especially important when designattributes are presentattributes are present

Design attributesDesign attributes are attributes that need to relate to each are attributes that need to relate to eachother in a precise fashionother in a precise fashion

Timing fitTiming fit

Size fitSize fit

R&D fitR&D fit

Leakage of Private informationLeakage of Private information

Private information can be a major source Private information can be a major source of competitive advantageof competitive advantage  

Use of the market can increase the risk of losing Use of the market can increase the risk of losing control of proprietary informationcontrol of proprietary information

The Economic Foundations of ContractsThe Economic Foundations of Contracts

Complete versus Incomplete ContractsComplete versus Incomplete Contracts

Factors that prevent complete contractingFactors that prevent complete contracting

Bounded rationalityBounded rationality

Difficulties in specifying performanceDifficulties in specifying performance

Asymmetric InformationAsymmetric Information

Role of Contract Law – Uniform Commercial CodeRole of Contract Law – Uniform Commercial Code

Transaction CostsTransaction Costs

Inability to write enforceable contracts that cover allInability to write enforceable contracts that cover allcontingencies and penalize shirkingcontingencies and penalize shirking

Transaction:Transaction: An autonomous exchange of goods or An autonomous exchange of goods or services between parties with no formal agreement that the services between parties with no formal agreement that the relationship will continue into the futurerelationship will continue into the future

Transactions CostsTransactions Costs:: the costs arising from organizing the costs arising from organizing and transacting exchangesand transacting exchanges

Key Characteristics of Transaction CostsKey Characteristics of Transaction Costs

Strong mutual reliance by each party after agreementStrong mutual reliance by each party after agreementhas been reachedhas been reached

Efforts by one or more parties to “sweeten” its end of the dealEfforts by one or more parties to “sweeten” its end of the deal

Relationship-Specific AssetsRelationship-Specific Assets

RSA lock parties into a relationship to a RSA lock parties into a relationship to a certain degreecertain degree

Relationship-specific assetsRelationship-specific assets (RSA) (RSA): an : an investment made to support a given investment made to support a given transactiontransaction

Cannot be redeployed to another transaction Cannot be redeployed to another transaction without some loss in productivity or adjustment without some loss in productivity or adjustment costcost

Forms of Asset FixityForms of Asset Fixity

Site SpecificitySite Specificity

Physical Asset SpecificityPhysical Asset Specificity

Dedicated AssetsDedicated Assets

Human Asset SpecificityHuman Asset Specificity

Rents and Quasi-RentsRents and Quasi-Rents

Rents and Quasi-Rents are associated with opportunity Rents and Quasi-Rents are associated with opportunity cost cost beforebefore (ex ante(ex ante) and ) and afterafter ( (ex postex post) the fundamental ) the fundamental transformationtransformation

Rent:Rent: the difference between the revenue the firm receives the difference between the revenue the firm receives and that which it must receive to enter into a given and that which it must receive to enter into a given relationshiprelationship

Quasi-RentQuasi-Rent:: the difference between (a) the revenue the the difference between (a) the revenue the seller would seller would actuallyactually receive if the deal were completed receive if the deal were completed according to the original terms of a contract; and (b) the according to the original terms of a contract; and (b) the revenue it revenue it must must receive to be induced to not exit the receive to be induced to not exit the relationship after a relationship-specific investment has relationship after a relationship-specific investment has been madebeen made

Rent = pQ-TVC-IRent = pQ-TVC-I  

Quasi-Rent = pQ-TVC-SQuasi-Rent = pQ-TVC-S

where:where:

p = pricep = priceQ = quantity producedQ = quantity producedTVC = total variable costTVC = total variable cost I = I = ex anteex ante opportunity cost of investment opportunity cost of investmentS = S = ex postex post opportunity cost of investment opportunity cost of investment

Rents and Quasi-RentsRents and Quasi-Rents

Example: Rents and Quasi-RentsExample: Rents and Quasi-Rents

(1)   Total variable cost(1)   Total variable cost

  

(2) (2) Ex anteEx ante opportunity cost opportunity cost

  

(3) Minimum revenue (3) Minimum revenue

required to enter the required to enter the

relationship (1)+(2)relationship (1)+(2)

  

(4) Actual revenue(4) Actual revenue

  

(5) Sellers rent(5) Sellers rent

  

(6) (6) Ex postEx post opportunity cost opportunity cost

  

(7) Minimum revenue require(7) Minimum revenue require

to prevent exit (1)+(6)to prevent exit (1)+(6)

  

(8) Quasi-rent (4)-(7)(8) Quasi-rent (4)-(7)

$3,000,000/year$3,000,000/year

  

$2,000,000/year$2,000,000/year

  

$5,000,000/year$5,000,000/year

  

  

$5,000,000/year$5,000,000/year

  

$0/year$0/year

  

$500,000/year$500,000/year

  

$3,500,000/year$3,500,000/year

  

$1,500,000/year$1,500,000/year

The Holdup ProblemThe Holdup Problem

The The holdup problemholdup problem arises when a party to a arises when a party to a contractual relationship exploits the other party’s contractual relationship exploits the other party’s vulnerability due to a relationship-specific asset.vulnerability due to a relationship-specific asset.

Manifest in the redistribution of quasi rents through:Manifest in the redistribution of quasi rents through:

contractual negotiationcontractual negotiation

unilateral actions by one party at the expense of unilateral actions by one party at the expense of anotheranother  

The Holdup Problem and Transactions costsThe Holdup Problem and Transactions costs

The holdup problem increases transaction The holdup problem increases transaction costs in four wayscosts in four ways::

Increased difficulty in contract negotiations and Increased difficulty in contract negotiations and more frequent renegotiationsmore frequent renegotiations

Investment to improve Investment to improve ex postex post bargaining positions bargaining positions

DistrustDistrust

Reduced investment in relationship-specific investmentsReduced investment in relationship-specific investments

Are there existing Are there existing suppliers that cansuppliers that canattain economiesattain economiesof scale that anof scale that anin-house unitin-house unitCannot? Do they Cannot? Do they possess executionpossess executioncapabilities that ancapabilities that anin house unit in house unit would not?would not?

Would “intermediate”Would “intermediate”arrangements (alliancesarrangements (alliancesetc.) suffice?etc.) suffice?

Are thereAre theresignificantsignificantrelationshiprelationship-specific assets?-specific assets?are thereare theresignificantsignificantcoordinationcoordinationproblemsproblemsinvolved in involved in leakage ofleakage ofprivateprivateinformation?information?

Is detailedIs detailedcontractingcontractinginfeasibleinfeasibleor tooor toocostly? costly?

Is commonIs commonownershipownershipneeded to needed to mitigate mitigate contractingcontractingproblems?problems?

Use theUse themarketmarket

VerticalVerticalintegrationintegration

Alliances,Alliances,joint venturesjoint ventures

Or otherOr otherclose-knitclose-knit

non-ownership non-ownership arrangementsarrangements

VerticalVerticalintegrationintegration

NoNo

NoNo

NoNoNoNo

NoNo

NoNo

YesYes YesYesYesYesYesYes

YesYes

Issue TreeIssue Tree