Vertical Boundaries

Chapter 10 Vertical boundaries Chapter 10 Vertical boundaries Aim of the chapter To generalize the factors that influence the musical modes in which proceedings on a perpendicular chain (value chain) should be/ atomic number 18 located on the grocery shaping continuum. Learning objectives On completion of this chapter and the essential pointing, you should halt a grievous to a lower placestanding of the undermenti unrivalledd terms and concepts motion plan of attack economics strategicalal calculation. Essential reading Buchanan, D. and A. Huczynski Organizational behaviour an introductory text. (London Prentice Hall, 2008) Chapter 18. Douma, S. nd H. Schreuder Economic addresses to presidential terms. (London Prentice Hall, 2008). Further reading Besanko, D. , D. Dranove and M. Shanley Economics of strategy. (New York Wiley, 1996). Coase, R. H. The problem of sociable damage, Journal of Law and Economics 3 1960, pp. 144. Grossman, S. and O. hart The ascend an d acquires of ownership a theory of steep and lateral integrating, Journal of Political Economy 94(4) 1986, pp. 691719. go awayiamson, O. E. The economics of organization the relations damage approach, Ameri asshole Journal of Sociology 87(3) 1981, pp. 54877. 10. 1 IntroductionAs noned in Chapter 1, we may meet the basic unit in systemal analysis as an exchange or dealing generated in the division of sweat. The division of labour (exogenous/endogenic Chapter 3) creates value or vertical chains for ex antiophthalmic factorle as shown in assure 10. 1(a) test from crude oil extraction to the retailing of oil colour products. We today act upon at the level of physical compositions or flyings (recognising that at a greater level of disaggregation the points in the chain atomic number 18 a like found on chains of the division of labour) and pose the inquiry as to where their boundaries should be located on the value chain.In fact the picture is usually to a great er extent interwoven than the one visualized in get word 10. 1(a). Activities usually matter on inputs at all points down the vertical chain, as depicted in general anatomy 10. 1(b). So organisations or commercialize exchanges could chasteness and set up each of these transactions. Furtherto a greater extent, some of these inputs may be common to the points on the master(prenominal) chain (see Appendix 1. 2 in this guide), same accounting services, in which case the picture looks more like Figure 10. 1(c). Note the part of di-graphs once a strain. 91 organisation theory an interdisciplinary approach a) oil extraction Refining Retailing (b) Shipping or pipe scattering (c) Accounting Figure 10. 1 In general we atomic number 18 enquire the question as to whether a particular transaction should be internalised (make) or left in the market place (buy), as depicted in Figure 10. 2 that is, whether a point on the chain should be a department/ function or div ision or remain separate. For the hour we cut back our attention to this simple pickax rather than the more distend positioning on the marketorganisation continuum.We shall return to the more exercise issue later on. Market (Price appliance) Figure 10. 2 Start by get hold ofing what the benefits and cost of using the market efficiency be. The benefits could include the following Independent unfluctuatings may be able to puff the benefits of economies of scale (i. e. see at an output that minimises unit costs) whereas internal departments may not. Unless the firm itself shadower absorb all the efficient output of the department, it must either operate below the optimal output level or sell on to an different firm.This might compromise any(prenominal) training advantages of the purchasing firm (see below). Independent firms be more subject to market disciplines than departments and may run down costs they fire control more effectively. Costs may be difficult to i dentify in departments. Firms might, though, attempt to replicate market incentives inside organisations. Tapered integrating refers to a situation where a firm is supplied partially by an independent firm and partially by its own department. This allows their relative cost structures to be compared. Independent firms (i. e. their managers) may have stronger incentives to introduce when compared with managers of departments. Organisation 92 Chapter 10 Vertical boundaries The costs of using the market might include the following Private entropy may be leaked to independent firms particularly if there is a read to share adept cultivation. The focal firm becomes to a degree dependent upon an independent fork overr (depending upon switching costs).Thus the latter has a berth resource (see Chapter 6) and may hire it to hold up the focal firm. It may prove difficult to control and co-ordinate liquefys of honorables and services down a vertical chain of independent firms. This may be particularly so where there is a submit to fit the products closely. Just-in sequence methods seek to overcome this problem and permit independent firms ofttimes with long-run relational hires (see below). The way most economists (following Coase and Williamson) intend around the weft amongst a market and organisational exchange/transaction is entirely definite choose the arrangement that minimises costs. The innovation here is to ntroduce the liking of transaction costs the costs involved in making (controlling and co-ordinating) the transaction. They are sometimes referred to as agency costs, and agency efficiency is found where they are minimised.So, if twain takings costs (which relate to technical efficiency) and transaction costs vary between organisational transactions and market transactions, thusly the total costs should be minimised. body process Now read personas 8. 1 and 8. 2 in D and S. If you would like to read a slightly more comprehensive economic approach to vertical integration, then read Besanko et al. 1996). In a world of full informed, intellectual actors where contracting is consummate, there are no transaction costs and the picking between market and organisational exchange is of no consequence (at least as conceived at bottom this framework) unless production costs vary (which, again, they should not under the same supposals). It is beca riding habit we relax both(prenominal) the assumptions of full rationality and full entropy in the context of substantive markets that transaction costs arise and the resource between market and organisational transaction is pertinent.Transaction costs theory is used both in a normative and coercive sense. The new assumptions are as follows Individual bounded rationality people are intentionally rational pull ahead limitedly so. Individuals are neither able to make very complex calculations nor to assimilate large amounts of information. As you might demand, soc iologists tend to like this assumption they see it as more realistic than the full assumptions of rationality. Opportunism individuals are not only self-interested hardly behave with guile.For ex vitamin Ale, in the context of spirited theory, individuals will issue promises which are not credible, make use of crooked information and they buttocksnot be trusted. Contracting about transactions is incomplete because of immanent indecision and incomplete information. Contracting can thus lead to ex punt self-seeking (namely, adverse selection) and ex post opportunism (namely, honorable hazard). These hazards will be exacerbated to the degree that there is little choice of transacting partners and so written reports (see Chapter 7) in respect of third parties will not constrain opportunism half-size numbers exchange. 3 Organisation theory an interdisciplinary approach Anticipated repeated action will make reputations important to both parties but if in the process ther e is development by doing, it is then costly to later switch exchange partner. Williamson (1981) calls this the fundamental transformation it ties the parties into the family relationship. Williamson also observes that parties to a transaction might have a preference for a certain type of transaction in addition to the costs and benefits. He calls this melodic line. In effect Williamson is introducing wider motives/utilities.Although the vocabulary introduced by Williamson is rather restrain at first sight, it has the advantage that it should link your thoughts into many of the brains you have already encountered. drill Think of transactions as a prisoners dilemma or trust spicy. Both parties would like to contract to carry out Pareto efficiency but each is wary of the other and in the absence of some mechanism to equilibrise this wariness, the exchange does not materialise the Nash vestibular sense. So what mechanisms are available? You should be able to list the mech anisms.They can be derived as follows. Competitive market the price as a adapted statistic here the prisoners dilemma does not model the situation. Organisation three possible mechanisms which can produce the Pareto-efficient outcome rather than the Nash equilibrium are 1. Authority and force-out. 2. Trust (cultural mechanisms). 3. Repeated transaction and reputation effects. As we have seen in earlier chapters, alongside monitoring and employment contracts (incentives), we expect organisations to avail themselves of a mixture of these mechanisms. besides note, if we think in terms of real markets rather than the ideal type of perfect markets, then the price mechanism is not suitable and perhaps these mechanisms might also apply at opposite positions on the marketorganisation continuum. We shall return to these matters later. Transaction cost economics embraces not only an unorthodox model of the individual but characterises aspects (dimensions, to use D and Ss terminology) of transactions that extend to upon the transaction costs.Activity Now read Section 8. 3 in D and S. The demarcation is that asset specificity (sometimes called relation-specific assets), uncertainty/complexity and frequency of exchange all join on the likelihood that a transaction will be laid (governed) inside an organisation (that is, make) rather than left to the market (that is, buy). Asset specificity comes in different forms site specificity adjacent sites, usually to economise on transport and dialogue costs physical asset specificity e. g. pipeline delivering crude oil utilise assets assets of a particular buyer dedicated to a particular relationship human asset specificity skills dedicated to a particular relationship which would be less valuable elsewhere. 94 Chapter 10 Vertical boundaries So we at present have a predictive theory about vertical integration and, incidentally, contracting out. By and large, empiric evidence has supported transaction cost theo ry particularly the impact of complexity in the context of uncertainty though one should entertain in mind what Williamson terms atmosphere.If there are widespread specific preferences for instance, managers might prefer the power implied by organisation this would complicate the picture. Furthermore, other factors might influence the choice between market and organisation. Regulation and taxation can confer advantages in deciding where profits are generated. For instance, taxation might favour small firms, and firms operating(a) across different national tax regimes may exit a chance it an advantage to contract out. An organisation might vertically integrate to gain a monopoly or demand information or to limit the flow of information to competitors (see below).Given all these possibilities, it is perhaps surprising that such strong empirical support for transaction cost theory is found. Appendix 10. 1 in this guide gives a slightly more orb approach to Williamsons reasonin g. The transaction costs approach still leaves open two questions 1. Will the integration, if appropriate, be backwards or forwards? 2. What type of organisation e. g. centralized or decentralised hierarchy? (I leave an answer to this question to Chapter 12. ) An addendum of transaction costs theory called property rights theory (which is not spine in D and S) provides an answer to the first question.When a transaction is internalised within an organisation, then ownership should (note the normative word) go to the party with the greatest impact upon the post-contractual rents. Activity Although this theory falls beyond this course, you might like to read Grossman and Hart (1986). Property rights theory is essentially a theory of dicker power. Incomplete contracts mean that residual extra-contractual control of assets is important. Ownership confers bargaining power over operational decisions when enforceable contracts break down.Anticipation of post-contractual hazards determin es earlier investment decisions. We presently need to complicate the picture by reintroducing the marketorganisation continuum, as in Figure 10. 3. I use the term continuum with a certain amount of licence as the alternative positions on it vary in a number of respects and could be reordered. The continuum runs from perfect competition, at one end, to integration or organisation, at the other. The question now is where should a transaction be placed on the continuum?Before answering this, let us look at what B and H have to say about the issues we have been discussing. 95 Organisation theory an interdisciplinary approach soupcon markets (perfect competition) Real markets Bargaining Franchising Long term contracts (network organisations) Tapered organisations Virtual organisations Alliances colligation venture Monopoly (small numbers) Externalities Asymmetric information Fixed cost ( happen to provider) Risk communion Cost plus (risk to buyer) Decentralised Integration (up/down) organisation Figure 10. Activity Now read Chapter 18 in B and H. Again, this chapter in B and H is extremely detailed you need to master the main ideas running down the left-hand margin. None of them is inconsistent with anything you have learned from D and S though note that the definition of vertical integration is in fact backwards vertical integration. Table 16. 3 in B and H gives a good overview of what I have termed the organisationmarket continuum. So let us now return to the continuum see Figure 10. 3 keeping the rich descriptions in B and Hs chapter in mind.First, look at what I have termed real markets. present we screw that in the real world the market environment is a good deal far from perfectly competitive. If the transaction is left to the price mechanism, then confused market distortions may undermine the price as a sufficient statistic. If, for instance, a supplier holds a monopoly, then backwards vertical integration may look attractive to a buyer. Likewise, a buyer might be tempted to vertically integrate backwards in order to acquire information or to reap benefits of vertical synergies (externalities).Long-term contracts (which will inevitably be incomplete) enable organisations to engage in a protracted relationship. They often top between buyers and suppliers in a vertical chain. D and S introduced the idea of relational contracting (an equivalent term). Remember, whenever you think in terms of contracts you need to think of the incentive, risksharing and information aspects. Fixed-term contracts put the risk of, say, increases in input prices to the supplier on the suppliers back. Cost plus contracts reverse the situation. amongst these two extremes, risk-sharing contracts can be objected.If the buyer and supplier have differing risk preferences then, other things being equal, an optimal contract can be found. web and virtual organisations (see B and H) are usually based upon long-term relational contracts, as are alliances. J oint ventures imply equity contribution from both the supplier and buyer. Centralised 96 Chapter 10 Vertical boundaries So the question now is where should a particular exogenously generated (by the division of labour) transaction be placed on the marketorganisation continuum? (The normative question. Alternatively, where is it placed and why? (The substantiative questions. ) Transaction cost economics claims to be both normative and positive and answers both questions minimise transaction and production costs But as we have seen, this is only part of the story. Activity Now read Section 9. 8 in D and S. In summary, the choice of the position of any vertical transaction on the marketorganisation continuum may be shaped by economies of scale anticipated information leakage getting information transaction costs residual property rights market imperfections regulation.But how are these various strands to be woven together? Unfortunately there is, as far as I am aware, no embr acing theory. B and H introduce you to the concept of corporate strategy and to what many organisation theorists term strategic choice. Although the idea that organisational arrangements innovationed to control and co-ordinate activities are a matter of choice was first introduced by sociologists in reaction to an earlier tradition that spoke of determinism often technological determinism we can now see this as an unhelpful distinction.Economists will always speak of choice where changing technology might either enhance or restrict the opportunity set which rational decision-takers face. We might then like to think of technological determinism when for whatever reason, the opportunity comprises a single option. I go on you to think in these terms even out if you want to question the suppressive notion of rationality (see Chapter 1). Activity Now read Chapter 9, particularly Sections 9. 19. 7, in D and S. Sections 9. 1 to 9. 6 of D and S cover issues of strategic planning that impinge upon organisation theory but are more often encountered in courses on management theory.You will benefit from reading them but they are not central to this unit. The central idea in management theory concerns the sources of what is termed sustained competitive advantage (SCA). why do some firms/organisations manage to sustain a better turn overment than their competitors, while operating in the same markets? Statistics tend to suggest that this is a common experience in many markets. Firms often earn above-average returns (loosely rents) on their assets over relatively extended periods of time. The assumption is that they have some characteristics (but which? that their competitors maintain it difficult to replicate or improve upon, at least during the time in which the advantage is sustained. From an organisational theory point of view the question to ask is are there ways of organising which can confer SCA? Notice that when an organisation possesses a competitive adva ntage, for whatever reason, then this implies that perfect competition is not operating. In so far as those running organisations seek SCA, they are trying to undermine 97 Organisation theory an interdisciplinary approach competitive forces.The early sections of D and Ss chapter show how game theory is an indispensable tool in studying competitive strategies. 10. 2 Vertical contracting and strategic choice Consider a transaction between B and S, as in Figure 10. 4. The problem is to design a contractual relationship to gain any possible rents. In terms of competitive advantage this amounts to placing the transaction on the marketorganisation continuum more effectively than the competition. Assume that there is need for relation-specific assets and a complete contract cannot be signed because of inherent uncertainties.Suppose now that B would like to persuade S to make the relation-specific investment. Ss ex ante problem is that in the absence of trust and credible promises, s/he ant icipates that, once the investment is made, B will take advantage of the situation. S anticipates that B will always be able, once the contract is entered into, to defraud contingencies not covered by the contract. By making the investment, S in effect confers bargaining power upon B who may even use this power to renegotiate the original contract (attempt to reduce the price of the good or service exchanged).S will then anticipate these example hazards and wherefore not invest the transaction will fail and both S and B will be less well off than they could be. thinking in terms of the (for the moment, one-shot) prisoners dilemma, S and B happen upon a Nash equilibrium rather than the Pareto-efficient outcome. So what can be make to achieve the Pareto superior outcome? S Figure 10. 4 B Some possibilities (neither exclusive nor exhaustive) are B makes the relation-specific investment (but then B confers bargaining power to S) B nd S make a joint investment an alliance or j oint venture S continues to make the investment but enters into a long-term contract with B (note that relation-specific investments tend to imply long-term relationships in the first place) forward or backward integration (here non-market incentives/ monitoring/authority/power/culture achieve the move from the Nash equilibrium to the Pareto outcome). But let us continue to ask that B wants to find a non-integration solution and still to encourage S to make the costly upfront relation-specific investment.S/he might do this in the recognition that S, as an independent organisation, may be relatively small, whippy and focused. S, furthermore, may be driven by a more entrepreneurial spirit than if it were to be a division or department in Bs bureaucracy. An independent S may be more innovative. Also small organisations tend to have lower labour costs (production costs). If so, then both S and B can benefit. The strategic problem is whether or not the transaction costs (ex ante and ex post) can be kept down while reaping these potential advantages.To offset Ss anticipated moral hazard problems, B necessitate to search for ways of reducing her/his own and increasing Ss relative bargaining power. To the degree that this proves possible, the strategy will offset Ss anticipated moral hazards. B need to make her/himself more dependent upon S before the contract is signed. One notable way s/he can secure this is to decentralise some design and innovation responsibilities to S. B now becomes partially dependent 98 Chapter 10 Vertical boundaries upon S. Furthermore, B can commit not only to a long-term contract but also to relatively unconditional contract renewal.These strategies do of course put B at some risk. But since we are thinking in terms of incentives to transact, you should by now recognise that risk-sharing is another aspect of the possible contracts between S and B that can be subjected to strategic reasoning. Not unreasonably, I think, assume that S is risk-averse and B is risk-neutral. So S will accept a reduction in rent in order to reduce his/her risk and, relatively speaking, B will be prepared to shoulder more risk. So, a risksharing, long-term contract can conceivably lead to a Pareto improvement. Think in terms of post-contractual price negotiation.With a fixed-cost contract any increase in Ss costs will have to be borne by S. S will be reluctant to sign such a contract. With a cost-plus contract, on the other hand, B will bear all the risks of Ss cost increases. Furthermore, S will have no incentives to hold costs down nor, perhaps more importantly, to insert in order to reduce costs. Clearly, B wants S both to inclose and, where possible, to hold down costs. It is not in Bs interests to take the risk from S and undermine these incentives. How can s/he provide appropriate incentives while reducing Ss risks and in so doing make the contract interesting to S?What B needs to do is to accept those risks of cost increases wh ich S cannot control while making S responsible for those s/he can control a tricky business. B needs to know the nature of Ss cost structure (an information problem no problem with full information but with information asymmetry it is another story) before s/he can achieve this. Of course, integration might dispel this problem but then we encounter the bureaucratic losses mentioned above. What can B do? Go back to your principalagent model (see Chapter 4). We can regard B as a principal and S as an agent.P (B) can acquire information by having more than one agent (S) operating in the same environment (in practice this is not easy). This is called multiple sourcing. It could be achieved by either multiple external sourcing or having an in-house comparator (tapered sourcing). But, of course, one needs to ask whether Bs sourcing requirements are of sufficient magnitude to reap any economies of scale across the multiple sources. If not, would it be sensible from an information leak age point of view to allow the sourcing organisation to sell to other organisations on the open market?If B has decentralised design to S then this might prove hazardous. As we have observed, long-term relationships (see Chapter 8) can invoke trust and reputation effects. Traditionally it was assumed that one of the advantages of integration into an organisation derives from the repeated interaction effects. B and S being in the same organisation, they repeatedly interact and, indeed, they will assume that there is a high enough probability that they will once again interact in the future. Thus prudent calculation can overcome the moral hazards in incomplete contracting.In game-theoretic terms B and S may play TFT (the folk theorem). B may also wish to protect her/his reputation for fair play. In short, an organisation can control and co-ordinate vertical relations by cultural means. However, long-term contracts with a continuation article also produce repeated interaction (the Jap anese were largely responsible, in the 1980s, for recognising this) and, thus, reputation and trust can be generated at other points on the marketorganisation continuum. Cultural mechanisms can operate outside formal organisations.If B and S can trust each other not to behave opportunistically, then the advantages of Ss independence and reduced transaction costs can be realised. 99 Organisation theory an interdisciplinary approach Finally, reverting to an extended value chain where Ss suppliers are also brought into the picture, we obtain the situation as in Figure 10. 5. R S B Price and market &gt &gt R S B Long-term contracts &gt &gt R S B Organisation span of co-ordination = 3 &gt &gt Figure 10. Should the whole chain be co-ordinated by integration (span of coordination) or perhaps co-ordinated by long-term contracts, etc.? If the latter, should B contract with S and R or should B contract with S and S with R? In either case we have examples of network organisation and even virtual organisation if the relationships are mediated by modern information technology. The strategic complexion of these sorts of organisation is little understood. Why dont you have a go I hope this section has given(p) you some appreciation of how to analyse organisation choices from a genuinely strategic point of view.Much of the above reasoning can be underpinned from a game-theoretic standpoint. This further supports my earlier contention that modern organisation theory often requires a knowledge of strategic thinking and game theory. A reminder of your learning outcomes On completion of this chapter and the essential reading, you should have a good sagaciousness of the following terms and concepts transaction cost economics strategic calculation. pattern examination question 1. Explain why a transaction should be placed in a market or an organisation. 100