VERTICAL BOUNDARIES OF THE FIRM CLASS 3 MAKE

VERTICAL BOUNDARIES OF THE FIRM CLASS 3

MAKE VS BUY o A firms decision to perform an activity itself or to purchase it from an independent firm is called a make or buy decision o All services can be done in house or out sourced. o Advertising o Raw Material Acquisition o Logistics o Customer Care o Warehousing o Recruitment o. Make or buy are two extremes. They are a continuum of possibilities for vertical integration. o Close to “make” firms can spin off subsidiaries o Close to “buy” firms can go into long term contracts

UPSTREAM AND DOWNSTREAM o. Goods in a production process “flow” along a vertical chain o. From raw materials to component parts, to manufacturing through distribution and retailing. o. The early steps are called “Upstream”, the later steps are “Downstream” o. Lumber used to make wooden furniture used to flow from upstream timber forests to down stream mills. Arms Length Market Transactions Long term contracts Less Integrated Strategic Alliances and Joint Ventures >>>>> Parent Subsidiary Relationships Perform activity Internally More Integrated

BENEFITS AND COSTS OF USING THE MARKET -Benefits - Market firms can achieve economies of scale. - Market firms are subject to the discipline of the market and must be efficient in order to survive. -Costs - Coordination of production flows through the vertical chin maybe compromised. - Private information maybe leaked. - Costs of transactions with independent firms that can be avoided by performing the activity in house.

5 MAKE OR BUY FALLACIES 1. Firms should make an asset rather than buy it, if that asset is a source of competitive advantage to the firm. 2. Firms should buy, rather than make, to avoid the costs of making the products 3. Firms should backward integrate to capture the profits of our suppliers for ourselves. 4. By vertically integrating the firm can obtain inputs “at cost”, thereby avoiding the risk of high input prices. 5. Firms should make rather than buy a distribution channel to gain market share at the expense of rivals.

CASE STUDY – MAKE VS BUY EMPLOYEES Firms can choose to make their employees or buy their employees. Making employees will result in training costs, but also giving skills that are needed just for the job in hand. Whereas, buy employees is cheaper but then you have to pay a higher wage than “buying” a school leaver and training them? 1. If you had a company would you make or buy your employees? 2. What type of employees should you make? 3. What type of employees would be more cost efficient to buy? 4. What are the deciding the factors between buying an employee or making one?

WHY BUY Conventional wisdom states that firms should focus their activities on what they do best and leaving else to market firms 1. Market firms may possess propriety information or patents that can enable them to produce at lower costs. 2. Market firms maybe able to aggregate the needs of many customers, thereby enjoying economies of scale. 3. Market firms might exploit their experience in producing for many customers to obtain learning economies.

BUREAUCRACY EFFECTS -Analyst’s stage that large firms suffer from bureaucracy. This means one of two problems - Agency Costs - Managers and workers make many decisions that contribute to the profitability of a firm. - Those who “knowingly” do no act in the best interest of the firm are SHIRKING. - Agency costs are the costs associated with shirking. -Influence Costs - Basically office politics - Therefore, top management does not know who is profitable and are influenced to make decisions that detrimental to the organization but good for the individual.

CASE STUDY - SONY Sony was a household name in the 1990’s with their walkman, and pushing the DVD standard. In 1998 they vertically integrated to software by buying Columbia Records which they renamed Sony Home Entertainment (SHE) Apple then launched the Ipod – which Sony responded with launching the Connect. The people running the Connect did not have control of SHE or the Walkman group, or the people who were doing Sony software on the Personal computer. This resulted in the Connect being a terrible failure. The walkman group refused to change their proprietary format to. mp 3 as the connect team wanted to which meant that their product was inferior. SHE refused to make their online store user friendly because they were afraid of piracy. Which meant the Apple Store was far superior. All of this meant that SHE, Walkman, Connect all had to be retrenched or shutdown completely. 1. How do you prevent the above from happening?

WHY MAKE? -The Economic Foundation of Contracts -Complete vs Incomplete contracting - Bounded Rationality - Difficulties specifying or measuring performance. - Asymmetric information -Coordination of production flows through the vertical chain - Timing Fit Sequence Fit Technical Specification Fit Colour Fit -Leakage of Private information -Transaction Costs -The Holdup Problem

THE ECONOMIC FOUNDATION OF CONTRACTS Contracts define the conditions of exchange. They maybe standardized like the back of an airline ticket or an invoice or Complicated like the sale of the Empire State Building in the 1960’s that had over 400 pages and over 100 lawyers were involved. • Why are contracts important? Contracts can be used to reduce shirking, but this depends on the 1. Completeness of the contract 2. The available body of contract law.

COMPLETE VS INCOMPLETE CONTRACTING Complete contracts cover all foreseeable outcomes. They specify everything. Most real world contracts are incomplete. Reasons why most contracts are incomplete. 1. Bounded Rationality refers to the limits on the capacity of individuals to process information, deal with complexity and pursue rational aims 2. Difficulties specifying or measuring performance refers to when performance is complex or subtle not even the most accomplished wordsmiths can be clear on what is the fulfillment of the contract. 3. Asymmetric information means that one group knows more about an activity than the other group. Therefore, they know how to protect themselves.

COORDINATION OF PRODUCTION FLOWS THROUGH THE VERTICAL CHAIN Timing Fit The launch of a Heineken marketing campaign must coincide increase production and distribution by its bottlers. Sequence Fit The steps in a medical treatment protocol must be properly sequenced. Technical Specification Fit opening The sun roof of a car must fit precisely into the roof Colour Fit The tops of the Benetton’s Spring Line up must match the bottoms.

LEAKAGE OF PRIVATE INFORMATION Give examples of private information? For each example explain what can be done with that information, and how damaging could it be?

TRANSACTION COSTS The concept of transaction costs was first described by Ronald Coase in his paper “The Nature of the Firm” He asked the question, in light of the efficiencies of the market, why do firms do so much economic activity within the firm? He concluded that there must be costs to using the market that can be eliminated by using the firm – i. e. Transaction Costs There was a new branch of economics called Transaction Cost economics. The adverse consequences of opportunistic behaviour. The costs of preventing opportunistic behaviour

HOMEWORK 1. Influence activities can happen in everyday life, in household, schools, and even among close friends” Can you give examples to support this statement? 2. Describe the vertical chain of a company that manufactures toffees and sells them in the Sri-Lankan Market? 3. Why do Keells, Cargills and other supermarkets have store brands for commodities. How do they get these products? Are they vertically integrated?

REFLECTION Reflective thinking and writing - is an important part of university life and work. As Plato said, 'The life without examination is no life. ' The ability to reflect on your experience and knowledge, and use that to make improvements, is a key part of your university-level thinking and your subsequent working life.

WHAT IS REFLECTIVE THINKING? To think and write reflectively you have to: Experience something Think about what happened Learn from the experience

WHAT IS REFLECTIVE THINKING? You think reflectively all the time, you probably just don't realize you're doing it. Have you ever missed the bus and then thought next time I’ll leave the house 5 minutes earlier'? This is an example of you being reflective: you thought about an experience and decided to learn from it and do something different the next time.

WHAT IS REFLECTIVE THINKING? As a student, and in the workplace, you will be asked to be reflective. Thinking or reflecting on the world around you, your experiences and actions will help you to develop and improve your skills.

WHAT IS REFLECTIVE THINKING? Reflection is: • Self awareness: thinking of yourself, your experiences and your view of the world • Self improvement: learning from experiences and wanting to improve some area of your life • Empowerment: putting you in control of making changes and behaving in a different way

WHAT IS REFLECTIVE THINKING? How to think reflectively There are several models of reflective practice which you can use to help you structure your reflective thinking and reflective writing. Two commonly used models are: Kolb's Learning Cycle (1984) and Schön (1991). You can put these models into practice through your reflective writing.

KOLB Kolb's Learning Cycle (1984) has four elements of a loop which you can start at any point, though normally you start with an experience:

SCHÖN'S MODEL Schön (1991) presented the concept of 'reflection in action' and 'reflection on action': Reflection in action Reflection on action • Experiencing • Thinking about something that has • Thinking on your feet happened • Thinking about what to do • Thinking what you would do differently next time • Acting straight away • Taking your time

SCHÖN'S MODEL Schön's theory is that there are two types of reflection, one during and one after an activity or event.

WRITING REFLECTIVELY How to write reflectively Creating a piece of reflective writing is different from other academic writing as it is more personal and you are writing about your experiences. The table on the next slide lists the differences between reflective and academic writing.

WRITING REFLECTIVELY Reflective writing Academic writing Personal account Impersonal account Consider your personal views Consider the views of others First person Third person Contemplates Argues and justifies Finds solutions to problems Compares and contrasts

REFLECTIVE THINKING AND MANAGERIAL DECISION MAKING • Individuals often don’t think about how they reflected. When asked, they were aware that they did reflect, but they had never considered it as something they could control or something they could use as a learning tool. • Enhancing decision making requires that we learn from our successes and failures and catalog mentally for future retrieval what has occurred and why.