Economics of Strategy
Chapter 3
Vertical Boundaries of the Firm
Anggoro Kasih
Vertical Chain
• Begins with the acquisition of raw
• Ends with the sale of finished
• Includes support services such as
Finance and Marketing
• Organizing the vertical chain is an
important part of business strategy
Vertically Integrated Firms
• In a vertically integrated firm, many of the steps
in the vertical chain are performed in-house.
Example: Scott Paper
• Some firms choose to outsource many of the
vertical chain tasks and become vertically
disintegrated. Example: Nike
Make versus Buy
• Decision depends on the costs and
benefits of using the market as opposed
to performing the task in-house
• Outside specialists may perform a task
better than the firm can
• Intermediate solutions are possible
(Examples: Strategic alliances with
suppliers, Joint ventures)
Support Services
• 􀁺 Accounting
• 􀁺 Finance
• 􀁺 Legal Support
• 􀁺 Marketing
• 􀁺 Planning
• 􀁺 Human Resource Management
Support Services
• Support services can be major sources of
value creation
 UPS – Logistics
 Toyota – Human Resource Manager
 Nike - Marketing
Some Make-or-Buy Fallacies
 Firm should make rather than buy assets that
provide competitive advantages
 Outsourcing an activity eliminates the cost of
that activity
Backward integration captures the profit margin
of the supplier
Backward integration insures against the risk of
high input prices
It makes sense to tie up the distribution channel
in order to deny access to the rivals
Reason to Buy
• Firm use the market (or Buy)
• 1. Market firms exploit economies of scale
• 2. Learning Curve
• 3. Eliminate “Bureaucracy”
Bureaucracy effect : Avoiding Agency and Influence Costs
Agency and Influence Costs
• The incentives to be efficient and innovative are weaker
when a task is performed in-house
• Agency costs are particularly problematic if the task is
performed by a “cost center” within an organization
• It is difficult to internally replicate the incentives faced
by market firms
Influence costs
• In addition to agency costs, performing a task in-house
will lead to “influence costs” as well
• “Internal Capital Markets” allocates scarce capital
• Allocations can be favorably affected by influence
• Resources consumed by influence activities represent
“influence costs”
Reason to “ Make”
• Complete Contract
• A complete contract stipulates what each party should
do for every possible contingency. No party can exploit
others’ weaknesses
To create a compete contract one should be able to
contemplate all possible contingencies
One should be able to “map” from each possible
contingency to a set of actions
One should be able to define and measure performances
One should be able to enforce the contract
Incomplete Contracts
Incomplete contracts
– Involve some ambiguities
– Need not anticipate all possible contingencies
– Do not spell out rights and responsibilities of parties
Factors that Prevent Complete Contracting
• Bounded rationality
• Difficulties in specifying/measuring performance
• Asymmetric information
Coordination of Production Flows Through the
Vertical Chain
• For successful coordination one party needs to make
decisions that depend on the decision made by others
• A good fit should be accomplished in several
– Timing
– Size
– Color
– Sequence
Leakage of Private Information
Firms would not want to compromise the source of their
competitive advantage, hence some activities cannot be
Transactions Costs
• Costs of using the market that are saved by centralized
• Transactions costs explain why economic activities
occur outside the price system
Sources of transactions costs
– Investments that need to be made in relationship specific
– Possible opportunistic behavior after the investment is
made (hold up problem)
– Quasi-rents (magnitude of hold up problems)
Relationship-Specific Assets
• Relation-specific assets are essential for a given
• Once the asset is in place, the other party to the contract
cannot be replaced costlessly, because the parties are
locked into the relationship to some degree
• Forms of Asset Specificity
• Relation-specific assets may exhibit different
• forms of specificity
• – Site specificity
• – Physical asset specificity
• – Dedicated assets
• – Human asset specificity
Rent and Quasi-rent
• The term ‘rent” denotes economic profits –profits after
all the economic costs, including the cost of capital, are
Quasi-rent is the excess economic profit from a
transaction compared with economic profits available
form an alternate transaction
• Firm A makes an investment to produce a component
for Firm B after B as agreed to buy from A at a certain
At that price A can earn an economic profit of π1
If A were to renege on the agreement and B is forced to
sell its output in the open market, the economic profit
will be π2
• Rent is the minimum economic profit needed to induce
A to enter into this agreement with B (π1)
• Quasi-rent is the economic profit in excess on the
minimum needed to retain A in the selling relationship
with B (π1- π2)
Effect on Transactions Costs
The holdup problem raises the cost of transacting
– Contract negotiations become more difficult
– Investments may have to be made to improve the ex-post
bargaining position
– Potential holdup can cause distrust
– There could be underinvestment in relation specific
•Anggoro Kasih

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