Transcript Incentives to vertical integration

Incentives to vertical integration
Vertical integration is the replacement of a
market transaction with an internal accounting
transfer
All business enterprises are
integrated to some degree; at the
same time, no enterprise is fully
integrated.
International Petroleum Majors
Firms such as British Petroleum and Gulf-Chevron are
“fully-integrated,” meaning they engage in crude
extraction, transportation by ship or pipeline, refining,
and wholesale and retail distribution.At the same time,
they are NOT integrated into manufacturing of pipelines
or oil extraction equipment. Thus, even the most
integrated firms are not ‘perfectly’ integrated.
The “make or buy” decision
•Should the big food processors such as General Foods
integrate upstream into agriculture?
•Should GM manufacture brakes for trucks at its Dayton, OH
parts facility, or should it “outsource.”
•Should SBC communications manufacture
telecommunications equipment “in house.”
•Should Amheiser-Bush get into the aluminum packaging
business?
•Should Sears manufacture appliances?
Issue: Why do firms choose to vertically
integrate (by way of merger or internal
expansion) instead of "outsource"?
Economists have identified three basic incentives
to vertical integration:
1. The elimination of transactions costs
2. Technological economies
3. Elimination of successive monopoly
The Coase contribution
Transactions costs that can be
avoided through “making”
instead of “buying” include:
•Search
•Negotiation
1
Professor Coase argued
that using markets can
be costly and that the
systematic replacement
of the market with
organization through
vertical integration
could result in vast cost
savings
•Contracting
•Contract compliance
Ronald H. Coase, "The Nature of the Firm," Economica,
Nov. 1937: 368-405]
1
Technological economies
•The integration of iron-making and steel-making
eliminates the cost that would be incurred to reheat
the iron if the two stages were non-integrated.
•Just-in-time inventory (JIT) management can
economize on firms' inventory carrying costs--but
only when units operating at different stages of
production are tightly coordinated.
The successive monopoly model
Consider the case of an upstream manufacturer
of motors and a downstream boat manufacturer
(both monopolists). The model is based on the following
assumptions:
1.
Manufacturing one boat requires one motor plus C dollars
worth of other inputs, where C = $100. Since there is one
motor per boat, Q measures motor and boat production.
2. The boat monopolist is a price-taker in the market for motors-i.e., there is no monopsony or oligopsony power (hear audio
explanation (wav)).
3.The marginal cost of manufacturing a motor is equal to (a
constant) $100.
Let PM denote the price of a motor. Thus the marginal
cost function for the boat maker is given by:
MC = PM + C
[1]
Recall that to maximize profits, MR should be equal to
MC. Thus:
MR = PM + C
[2]
Thus the derived demand function (D')(hear audio
explanation (wav)) for motors is given by:
PM = MR – C
[3]
$
800
Successive Monopoly: Pre and PostMerger
Pre-merger boat price
700
650
Post-merger boat price
PM + C
500
MC’ (Motors and C)
Derived demand for motors
MC (Motors)
M
200
100
M’
0
140
D
D’
300
700
800 Q
Summary
Back to Lesson 7
Notice the following:
• If the manufacture of motors and boats remains nonintegrated, then PM = $400; hence PM + C = $500; hence the
price of boats will be equal to $650.
•However, if the two monopolists merge, then the marginal
cost of manufacturing a boat declines from $400 to $200. The
profit maximizing price of boats decreases from $650 to
$500.The quantity produced of boats increases from 140 to
300. Hence vertical integration is welfare-enhancing.
• Notice that profit increases by the red shaded area.