Managerial economics and organizational architecture 5e ch019

Managerial Economics and Organizational Architecture, 5eChapter 19: Vertical Integration and Outsourcing... Vertical Integration• Firms must identify the costs and benefits of acquiring

Managerial Economics and Organizational Architecture, 5e

Chapter 19: Vertical Integration and Outsourcing

Vertical Integration

• Firms must identify the costs and benefits

of acquiring inputs or services through

competitive markets versus producing

them internally

• Some activities are better outsourced than

others

• Tradeoffs are involved with acquiring

inputs through long-term contracts versus

vertical integration

The Vertical Chain

• Inputs flow downstream from raw

materials to finished goods

• Vertical integration occurs when a firm

participates in more than one successive

stage of the vertical chain

The Vertical Chain of Production

6 Transportation and storage

7 Retailer distribution and service

(computer stores)

Accounting Finance Human resources

Legal Marketing Customer support services

Steps in the vertical chain Support services

Vertical Chain of Production

• Forward integration

– Forward integration occurs when a firm moves

into distribution or additional finishing work

• Backward integration

– Backward integration occurs when a firm begins

to produce its own inputs

• Outsourcing

– Movement away from vertical integration

– Spot markets

– Contracting

Spot markets Long-term contracts Vertical integration

Benefits of Buying in Competitive Markets

• Economies of scale

– If the firm does not use sufficient volume to

reach economies of scale, the market will be

able to produce the input at a lower average

cost

• Incentives for efficient production

– Motivating internal suppliers to produce

efficiently is more difficult because market

force are not at play

Reasons for Nonmarket

Transactions

• Why not use the market for all

transactions?

• Transactions costs

– Costs of searching for a supplier,

negotiating prices, and enforcing contracts

• Some inputs can be produced at a lower

overall cost because of high transactions

costs

Firm-Specific Assets

• Assets that have substantially greater

value in their specific use, but not much

value outside of the firm

• Site specificity

– Asset located in a specific area is useful only

to producers in that area

• Physical asset specificity

– Product design makes the asset useful to only

a few buyers – specialized tool

Firm-Specific Assets

• Human asset specificity

– Specialized knowledge on the part of the

parties is required to complete the transaction

• Dedicated assets

– Facilities must be expanded because of the

requirements of a specific buyer

– If reputation is important, outside distributors

may have an incentive to free ride on the

quality of the products they distribute

• Extensive coordination

– If timing or fit are important, the costs of

contracting will increase

More Reasons for Nonmarket

Transactions

• Taxes and regulation

– May be able to shift profits from a high taxed

firm to a lower taxed unit

• Market power

– If the input is used in two different markets,

price discrimination may not work if resell

cannot be stopped

Using Vertical Integration to

relievers, the seller can charge the cancer drug firms $105

Circumstances Favoring Vertical

Integration

• Incomplete contracting

• Ownership and investment incentives

• Specific assets and hold-up auctions

Incomplete Contracting

• It is difficult to specify all rights and

responsibilities

• Not all contingencies will be covered

• Costs of contracting will increase

Ownership and Investment

Incentives

• Vertical integration keeps ownership rights

within the firm

Specific Assets and Hold-Up

• If the input producer invests in a specific

asset, the purchaser may take advantage

of this investment (holdup)

• To avoid holdup more complete contracts

must be written

• Costs will increase

• As the asset becomes more specific,

vertical integration is preferred

Asset Specificity, Uncertainty,

and the Procurement Decision

Market transaction

Market transaction

Contract

Contract

Contract or vertical integration

Contract or vertical integration

Contract or vertical Vertical

Circumstances Favoring

Long-Term Contracts

• Nonspecific assets

• Stable environments

• Incentive distortions

Contracting with Distributors

• To avoid free-rider problems

– Charge franchisees for advertising

– Give them exclusive territories

• Double markups

– Exclusive territories may result in double

markup

– Combined profits will be lower

– Requiring a purchase quota may avoid this

problem

Optimal Output in an Example

of the Double Markup Problem

Example of Double Markups

SUVmart uses $30,000 as their MC and this results in them raising prices even further and selling less than the optimal number of units

Recent Trends in Outsourcing

• Global competition

• New production technologies

• New information communications

technology

• Excess capacity