Transcript Managerial Economics and Organizational Architecture

Managerial Economics and Organizational Architecture, 5e
Managerial Economics and
Organizational Architecture, 5e
Chapter 19: Vertical
Integration and Outsourcing
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Managerial Economics and Organizational Architecture, 5e
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
19-2
Managerial Economics and Organizational Architecture, 5e
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
19-3
Managerial Economics and Organizational Architecture, 5e
The Vertical Chain of Production
personal computers
Steps in the vertical chain
Support services
1. Raw materials (chemicals, metals,
rubber)
2. Transportation and storage
3. Intermediate-goods processors
(plastics, chips, operating
software)
4. Transportation and storage
5. Assemblers (PC manufacturers)
6. Transportation and storage
Accounting
Finance
Human resources
Legal
Marketing
Customer support services
7. Retailer distribution and service
(computer stores)
19-4
Managerial Economics and Organizational Architecture, 5e
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
19-5
Managerial Economics and Organizational Architecture, 5e
Outsourcing
choosing along a continuum
Spot markets
Purchased at market
price with no longterm commitment
Long-term contracts
Vertical integration
Part or service
produced internally
19-6
Managerial Economics and Organizational Architecture, 5e
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
19-7
Managerial Economics and Organizational Architecture, 5e
Competitive Equilibrium
$
$
LRMC
Price and cost per unit of output
(in dollars)
LRAC
S
D
Q
i
Quantity of output (firm i)
Firm
Quantity of output
Industry
19-8
Managerial Economics and Organizational Architecture, 5e
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
19-9
Managerial Economics and Organizational Architecture, 5e
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
19-10
Managerial Economics and Organizational Architecture, 5e
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
19-11
Managerial Economics and Organizational Architecture, 5e
Transactions Costs
• Measuring quality
– Market firms may have an incentive to provide
lower quality inputs
• Reducing externalities
– 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
19-12
Managerial Economics and Organizational Architecture, 5e
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
19-13
Managerial Economics and Organizational Architecture, 5e
Using Vertical Integration to
Price Discriminate
Price (in dollars)
$
$
200
105
The pain reliever
firm may arbitrage with
the cancer firm. By forward
integrating into pain
relievers, the seller
can charge the cancer
drug firms $105
100
Demand
55
10
MR
Cancer drug
MC
Demand
MC
10
Q
MR
Q* = 65
Q
170
Pain reliever
19-14
Managerial Economics and Organizational Architecture, 5e
Circumstances Favoring Vertical
Integration
• Incomplete contracting
• Ownership and investment incentives
• Specific assets and hold-up auctions
19-15
Managerial Economics and Organizational Architecture, 5e
Incomplete Contracting
• It is difficult to specify all rights and
responsibilities
• Not all contingencies will be covered
• Costs of contracting will increase
19-16
Managerial Economics and Organizational Architecture, 5e
Ownership and Investment
Incentives
• Vertical integration keeps ownership rights
within the firm
19-17
Managerial Economics and Organizational Architecture, 5e
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
19-18
Managerial Economics and Organizational Architecture, 5e
Asset Specificity, Uncertainty,
and the Procurement Decision
Uncertainty
Low
Asset Specificity
Low
Medium
High
Market
transaction
Contract
Contract
Medium
High
Market
transaction
Market
transaction
Contract or
vertical
integration
Contract or
vertical
integration
Contract or
vertical
integration
Vertical
integration
19-19
Managerial Economics and Organizational Architecture, 5e
Circumstances Favoring LongTerm Contracts
• Nonspecific assets
• Stable environments
• Incentive distortions
19-20
Managerial Economics and Organizational Architecture, 5e
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
19-21
Managerial Economics and Organizational Architecture, 5e
Optimal Output in an Example
of the Double Markup Problem
$
Price and cost per automobile
(in dollars)
55,000
P*w =
30,000
5,000
MC
MR
Q* = 250
D
Q
Quantity of automobiles
19-22
Managerial Economics and Organizational Architecture, 5e
Example of Double Markups
$
$
55,000
Price per unit (in dollars)
55,000
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
P*r =
42,500
P*w =
30,000
5,000
30,000
MC
MR
D
Q* = 125
275
Quantity
AutoCorp
Q
MC
MR
Q* = 125 275
Quantity
D
550
Q
SUVmart
19-23
Managerial Economics and Organizational Architecture, 5e
Recent Trends in Outsourcing
• Global competition
• New production technologies
• New information communications
technology
• Excess capacity
19-24