Vertical Integration and The Scope of the FirmFrom Business Strategy to Corporate Strategy: The Scope of the FirmTransactions Costs and the Scope of the FirmTransactions Costs and The Existence of the FirmChanges in Aggregate Concentration Over TimeDeterminants of Changes in Corporate ScopeThe Costs and Benefits of Vertical Integration: BENEFITSThe Costs and Benefits of Vertical Integration: COSTSWhen is Vertical Integration More Attractive than Outsourcing?Designing Vertical Relationships: Long-Term Contracts and Quasi-Vertical IntegrationRecent Trends in Vertical RelationshipsDifferent Types of Vertical RelationshipVertical Integration and The Scope of the FirmVertical Integration and The Scope of the Firm•Transactions Costs and the Scope of the Firm--Why does the firm exist?--The evolution of firms and markets•The Costs and Benefits of Vertical Integration•Designing Vertical Relationships•Recent TrendsOUTLINEFrom Business Strategy to Corporate Strategy: The Scope of the FirmFrom Business Strategy to Corporate Strategy: The Scope of the Firm•Business Strategy is concerned with how a firm computes within a particular market•Corporate Strategy is concerned with where a firm competes, i.e. the scope of its activities•The dimensions of scope are–geographical scope–vertical scope–product scopeP1P2P3C1C2C3VerticalProduct GeographicalScope Scope ScopeV1V2V3P3P2P1C3C2C1V1V2V3[A] Single Integrated Firm[B] SeveralSpecialized Firms linkedby MarketsIn situation [A] the business units are integrated within a single firm.In situation [B] the business units are independent firms linked by markets.Are the administrative costs of the integrated firm less than the transactioncosts of markets?Transactions Costs and the Scope of the FirmTransactions Costs and the Scope of the FirmTransactions Costs and The Existence of the FirmTransactions Costs and The Existence of the Firm•Transaction cost theory explains not just the boundaries of firms, also the existence of firms.•In 18th century English woollen industry, no firms – independent spinners and weavers linked by merchants.•Residential remodeling industry -- mainly independent self- employed builders, plumbers, electricians, painters.•Key issue -- transaction costs of the market vs. administrative costs of firms.•Where transaction costs high—firm is more efficient means of organizationNote: transaction costs = cost of locating, negotiating, and enforcing a contract.Changes in Aggregate Concentration Over TimeChanges in Aggregate Concentration Over Time• For most of the 19th & 20th centuries industrial firms have expanded their vertical, geographical and product scope. Why?• From the late 1970s to the mid-1990s, this trend reversed. Large companies began downsizing, outsourcing, and refocusing. Why? • Why the recent renewal of concentration in the industrial sector?1930 1940 1950 1960 1970 1980 1990 199750%20%35%Sales of 100 biggest cos. as % of US industrial outputDeterminants of Changes in Corporate ScopeDeterminants of Changes in Corporate Scope1800 – 1980 Expanding scale and scope of industrial corporations due todeclining administrative costs of firms:• Advances in transportation, information and communication technologies• Advances in management—accounting systems, decision sciences, financial techniques, organizational innovations, scientific management1980 – 1995 Shrinking size and scope of biggest industrial corporations. Increasingly Increased no. of managerial Admin. costs ofturbulent decisions. Need for fast firms rise relative external responses to external to transaction environment change costs of markets1995 – 2004 Rapid increase in global concentration (autos, aluminium, oil, beer, banking, cement). Key drivers: quest for market power and scale economies.Also, large corporations becoming more entrepreneurial and agileThe Costs and Benefits of Vertical Integration: BENEFITSThe Costs and Benefits of Vertical Integration: BENEFITS•Technical economies from integrating processes e.g. iron and steel production—but doesn’t necessarily require common ownership•Superior coordination •Avoids transactions costs of market contracts in situations where there are:-- small numbers of firms-- transaction-specific investments-- opportunism and strategic misrepresentation-- taxes and regulations on market transactionsThe Costs and Benefits of Vertical Integration: COSTSThe Costs and Benefits of Vertical Integration: COSTS•Differences in optimal scale of operation between different stages prevents balanced VI•Strategic differences between different vertical stages creates management difficulties•Inhibits development of and exploitation of core competencies•Limits flexibility -- in responding to demand cycles -- in responding to changes in technology, customer preferences, etc.(But, VI may be conducive to system-wide flexibility)•Compounding of riskWhen is Vertical Integration More Attractive than Outsourcing? When is Vertical Integration More Attractive than Outsourcing? How many firms are available The fewer the companies to undertake the activities? the more attractive is VIIs transaction-specific investment If yes, VI more attractiveneeded?Does limited information permit VI can limit opportunism cheating? Are taxes or regulation imposed VI can avoid themon transactions?Do the different stages have similar Greater the similarity, the optimal scales of operation? more attractive is VIAre the two stages strategically Greater the strategicsimilar? similarity ---the more attractive is VIHow great the need for entrepreneurship Greater the need, the greater& continual upgrading of capabilities the disadvantages of VIHow uncertain is market demand? Greater the unpredictability ----the more costly is VIAre risks compounded by VI increases risk.linkages between vertical stagesDesigning Vertical Relationships: Long-Term Contracts and Quasi-Vertical IntegrationDesigning Vertical Relationships: Long-Term Contracts and Quasi-Vertical Integration•Intermediate between spot transactions and vertical integration are several types of vertical relationships---such relationships may combine benefits of both market transactions and internalization•Key issues in designing vertical relationships-- How is risk allocated between the parties?-- Are the incentives appropriate?Recent Trends in Vertical