Transcript lecture 1 - Vanderbilt University

Chapter 20
Managing Vertical Relationships
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Review of Chapter 19
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Companies are principals trying to get their divisions
(agents) to work profitably in the interests of the parent
company.
Transfer pricing does not merely transfer profit from one
division to another; it can result in the movement of
assets to lower-value uses. Efficient transfer prices are
set equal to the opportunity cost of the asset being
transferred.
A profit center on top of another profit center can result
in too few goods being sold; one common way of
addressing this problem is to change one of the profit
centers into a cost center.
Review of Chapter 19 (cont.)
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Companies with functional divisions share functional expertise
within a division and can more easily evaluate and reward
division employees. However, change is costly, and senior
management must coordinate the activities of the various
divisions.
Process teams are built around a multi-function task and are
evaluated based on the success of the project on which they are
working.
When divisions are rewarded for reaching a budget threshold,
they have an incentive to lie to make the threshold as low as
possible to make sure they get their bonuses. In addition, they
will often pull sales into the present, and push costs into the
future, to make sure they reach the threshold level.
Anecdote: Large Power Company
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Electricity sold to customers at rates regulated by the state
“PUC”
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The Power Company is contemplating purchasing the Coal Mine
that supplies them with coal
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Form a multi-divisional company
Direct the Coal Division to raise the transfer price of coal sold to the
Power Division
Increase in the price of coal raises the marginal cost of producing
electricity
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Allowed to earn nine percent return on capital
Under the profit regulation, allows the Power Division to raise
electricity prices
Coal Mining Division earns more on the coal it sells
Power Division is allowed to raise the regulated price of electricity so
that its profit does not fall
In other words, the Coal Mine is more valuable as a sister
division to the Power Company, than it is as an independent
company
Caveat: Beware Acquisitions
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Do NOT buy a customer or supplier simply
because they are profitable
Without some kind of synergy, the value of
the upstream supplier or competitor is exactly
equal to the size of its profit stream – not
moving assets to higher value uses
Discussion: AT&T Cable Acquisitions
Evading Regulation Motive
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One of the simplest and easiest-to-understand
reasons for vertical integration
If there is unrealized profit at one stage of the
vertical supply chain – as happens when there are
regulations preventing one firm from earning higher
profit – vertical integration, tying, or bundling can
give the regulated firm a way to evade regulation
and earn higher profit
Discussion: Rent Control
Discussion: Multi-National Companies
Solving the Double-Markup Problem
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Discussion: Gasoline refiners selling branded
gasoline
This problem can be analyzed more generally as a
prisoners’ dilemma faced by any two firms in the
same vertical supply chain or by any two firms
selling complementary goods
The double markup problem occurs when firms
selling complementary products set price in
competition with each other
Vertical integration is one way of addressing the
double marginalization problem – commonly owned
firms can coordinate more easily on lower prices to
raise profit
Aligning Retailer Incentives with
Manufacturer Goals
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Discussion: Getting retailers to invest in demand-enhancing
services
 With a smaller profit slice, retailers may under-invest
 Hard to write complete contracts to cover all cases
 Intra-brand competition can be controlled by means such as
granting exclusive territories, setting minimum retail prices, etc.
 Guarantees retailers a higher profit level creates incentive to
provide demand-increasing services
 Examples??
Limiting intra-brand competition also helps reduce free-riding
Many of these tactics may be illegal under antitrust laws
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Especially for companies with dominant market shares
Price Discrimination
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Two separate consumer groups who use
same product in different manners
Integrating downstream can allow
manufacturer to price discriminate
Example: Herbicide users (home gardeners
and farmers)
Price discrimination at the wholesale level is
much more difficult (and may be illegal)
Outsourcing
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The opposite of vertical integration – but
decisions should employ the same logic
Outsource an activity to an upstream supplier
or downstream customer only if they can do it
better or more cheaply than you
Typical reason is to gain advantages of
economies of scale or scope
Consider whether you are sacrificing any
integration benefits before you outsource
Alternate Intro Anecdote
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The Aluminum Company of America (Alcoa) was the only
domestic supplier of aluminum ingots prior to 1930, which were
used for a variety of purposes
 An addition to the production process in the iron and steel
industry, used to improve the quality of the final product.
 Manufacture of cooking utensils
 Production of electric cable
 Automobile and aircraft parts constituted the final two end
markets.
Consumers in these diverse markets varied widely in their
willingness to pay for aluminum ingots.
 Demand for aluminum in the iron/steel industry and in the aircraft
industry was relatively inelastic
 In the other three industries, demand was much more elastic
Alternate Intro Anecdote (cont.)
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The potential for arbitrage created a barrier to implementing
a scheme to increase prices to iron/steel and aircraft
consumers while generally reducing price to the other three
markets.
To successfully implement its price discrimination scheme,
Alcoa was forced to forward integrate into the three
relatively elastic markets.
By moving into the cookware, electric cable, and
automotive parts markets, Alcoa gained control over
potential resales of aluminum ingot and was able to
maintain high prices to the iron/steel and aircraft parts
markets.