Vertical boundaries of the firm Ref Economics of
Vertical boundaries of the firm [Ref. - Economics of strategy by Besanko] ECONOMICS OF CONTRACT
VERTICAL CHAIN From raw material acquisition to distribution and sale of finished goods or services Vertically integrated firms – Scott paper Vertically disintegrated firms – Nike, Benetton, Chrysler - A choice that affects efficiency of production
MAKE OR BUY Make: in-house activity Buy: rely on an independent firm to do it (perhaps under a contract) Backward integration: A distributor looking backward (Ex. Home box office produced its own programming) Forward integration- A material supplier moving forward (Ex. Alcoa manufactured aluminum foil, participation in all major aspects of the industry: technology, mining, refining, smelting, fabricating, and recycling)
MAKE OR BUY CONTINUUM Arm’slength market trans. Less integrated Long-term Strategic contracts alliances and jointventures >> >> Parent In-house subsidiary activity relation >> More integrated
VERTICAL CHAIN FOR FURNITURE PRODUCTION AND SALE Raw inputs (trees, iron, cows) Accounting Finance Transportation & warehousing HRM Intermediate goods preprocessors (lumber mills, metalworking shops, tanneries) Transportation & warehousing Assemblers (furniture mfg. ) Transportation & warehousing Retailers (furniture stores) Legal Support Marketing Planning Other support services
VERTICAL DISINTEGRATION Buy from specialists from the market (market firms) Ex. - Automobile assmblers Compare cost and benefit of using the market and the activity of doing in-house These costs and benefits shape the contract (if used) and contractual behaviour
COST & BENEFIT OF USING MARKET Benefits Costs Economies of scale (many Coordination problem in the customers) vertical chain Subject to market discipline Leakage of (more efficient and information innovative) private A huge corporate may hide Cost of transacting with a division’s inefficiency independent firm that can be avoided
REASONS TO BUY: TANGIBLE BENEFITS i) Possession of proprietary information and patent ii) Aggregating needs of many customers: scale economy (Lucas Varity or Robert Bosch Corp) iii) Producing for many firms might help in learning economics
REASONS TO BUY: INTANGIBLE BENEFITS i) Less Agency costs: Agency cost is more in large integrated firms. What is it? Cost associated with slacking and administering controls to deter slack effort Agency costs are difficult to detect: a) Allocation of joint cost amongst divisions b) Presence of cost centers (difficult performance evaluation): disincentive of having committed customers internally c) Willingness to ignore it It can be ameliorated by using performance based contracts with employees (may not be eliminated)
CONT… ii) Reduction in influence cost (arises when transactions are internally organised) - cost of influencing internal capital market [Loss of scale economy, unavoidable unused capacity cost, etc] Results in misallocation of resource in internal capital market
COST OF USING MARKET i) Coordination problem ii) Information privacy of trading partner iii)Transaction costs These problems can be traced to cost of writing and enforcing contracts Reasons to make decision is associated with limitations of contract.
ECONOMIC FOUNDATIONS OF CONTRACTS Contracts define the conditions of exchange Ø May be in a standard form: Terms of an airline tkt Ø Very complex to suit a specific transaction: A concession agreement for development of a port Use of contracts in make-or buy decisions: Ø List of task each party expects the other to perform Ø Remedies for breach [one does not trust the other] Ø Protection from opportunistic behaviour The extent of protection depends on: Ø Ø Ø Completeness Available body of contract law
COMPLETENESS OF CONTRACTS An ideal thing [all real world contracts are incomplete] Eliminates opportunistic behaviour [each and every conceivable contingency is factored in]: as the transaction unfolds, opportunities might creep in for one party Means: Contingencies > mapping > each party’s actions > satisfactory and measurable performance > clarity lends enforceability Incomplete contracting: Open-endedness or ambiguity
A CASE OF INCOMPLETE CONTRACT Cook v. Deltona Corp: Deltona- 1971 contract to sell land in Florida to Cook Title to be transferred in 1980 (filling underwater land) Policy of Fed govt. made it difficult to obtain dredge-and-fill permit 1976: Deltona backed out on ground of impossibility [Contract did not specify what Cook can do and what is the responsibility of Deltona in this case- incomplete contracting] Defense raised by Deltona: Bounded rationality Outcome: Cook own [9 years of litigation] Decision: Bounded rationality could be a defense, but symptoms of toughening of policy were existing at the time of contract, risk should have been factored in the contract
FACTORS PREVENTING COMPLETE CONTRACTING Bounded rationality Difficulty in measuring performance Examples: Ø Ø Lessee to bear excess wear and tear (What is excess? Less than showroom condition? ) What is engine thrust as per Boeing engineers? Asymmetric information Example: A component supplier to get bonus if quality standards are met to endure product durability (Component manufacturer knows what quality checks are there already!)
ROLE OF CONTRACT LAW Ø Ameliorates problems of incomplete contract Ø Standard provisions for a wide range of transactions Ø Need not be repeated in every transaction Ø However, not a perfect substitute for complete contracting i) As generally worded doctrines are enshrined (“reasonable time”) ii) Litigation is a costly way to complete contracts, destroys relations (divorce in business marriages), new relations may be difficult or impossible
CONTRACTS AND COORDINATION Coordination to succeed: Decisions of one depend on decisions of others, working together assures a good fit among all dimensions of production Examples: Ø Timing fit (movie release with ad campaign) Ø Size fit (Sun roof of a car with roof opening) Ø Color fit (Tops in Benneton to match bottoms) Ø Sequence fit (Steps in a medical treatment) Ø R&D fit (accurate sharing of information amongst researchers) How do contracts try to bring in this fit? Specifying delivery dates, design tolerance, or other performance targets and associated penalty for not meeting these targets
CONT… Coordination is especially important in processes with design attributes (misfit in these attributes leads to significant loss of economic value) Examples of design attributes: Timely delivery of components, Auto sunroof glass and opening, course sequencing in MBA curriculum Examples of attributes which are not design attributes: Sequencing of sports activities in a summer camp Incomplete contracts fail to bring the fit.
COST OF USING MARKET: LEAKAGE OF PRIVATE INFORMATION Information no one else knows Leads to judicious use of market (Benetton: Dyeing of fabrics in-house, Cannon produces engines for HP laser printers, but HP did not share PCL software) Contracts are used to take care of this through noncompete clauses. Example: Non-compete clause in employment contracts
TRANSACTION COSTS Ronald Coase in “The Nature of the firm”: “Why so much economic transaction happens outside the pricing system? There must be costs associated with market that can be eliminated by using the firm (in-house) Transaction costs = Adverse consequence of opportunistic behaviour + cost of trying to prevent it (time & cost of negotiating, writing and enforcing contracts) Arises because of incomplete contracts. Contract can ameliorate this, but cannot eliminate this.
THEORETICAL CONCEPTS OF TRANSACTION COST ECONOMICS Ø Relationship-specific asset Ø Rent and Quasi-rent Ø Holdup problem
RELATIONSHIP-SPECIFIC ASSETS An investment to support a given transaction Ø Essential for efficiency of a particular transaction Ø Costless switching to other transaction is not possible (sacrifice in productivity of the asset or some cost incurred to adapt it to the new transaction) Forms of asset specificity: Site specificity: side-by-side location of plants Ø Physical specificity: Physical or engineering properties are configured (Ex- custom tailored moulds for glass) Dedicated assets: A particular buyer Human Asset specificity: Rockwell’s unsuccessful experience in electronic calculators and digital watches
RENTS & QUASI-RENTS Rents: Profit when you build the plant if everything goes well Quasi-rent: Rent minus rent from next-best alternative use Quasi-rent tells about the magnitude of holdup problem that arises in case of relationship -specific assets
HOLDUP PROBLEM A firm holds up its trading partner by attempting to renegotiate the terms of a deal Larger possibility in case of incomplete contracting Contractual breach can transfer a part of QR to the customer Calculate holdup impact before entering into a contract
HOLDUP PROBLEM AND TRANSACTION COST Holdup raises cost of arm’s length transaction by i) Making contract negotiation and renegotiation more difficult (time and cost would be more) i) Holdup induces parties to make investments to improve post-contractual bargaining position (Standby production facility, Multi-sourcing) i) An intangible cost of holdup is distrust: raises cost of contracting i) Reduced investment contractors) (Example-British sub-
RECAP Use the market Full view Are there existing firms with economies of scale that inhouse unit cannot have? Do they have better execution capability? No No Y e s Significant relationshipspecific assets? Significant coordination problems? No Y e s No Detailed contracting infeasible or very costly Leakage of private info? Would intermediate arrangements (alliances, JVs) do? Y e s Can common ownership mitigate contracting problems? No Yes No Y e s Vertical integrat -ion Alliances, JVs Vertical integration
THE MOOT POINTS Where contracts are needed? What do they do for you? Law lays down a standard foundation Should we be interested to know what the law talks about? NEXT STEP: CONTRACT
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