Vertical Integration - notes from my last lesson

In the XIX and XX centuries, companies had been growing in size and scope, absorbing transactions that had previously taken place across markets. Coase’s thought indicated the increased efficiency of the firms in organizing economic activity to two main factors: technology and management techniques developing.

On the same way of thought, Galbraith predicted that the inherent advantages of firms over markets in planning and resource allocation would result in increasing dominance of capitalist economies by a small number of giant corporations. This was a famous wrong prediction in management and business administration.

In fact, by the end of the 1990s, we assisted to a sharp reversal of the trend toward increased corporate scope. The new dominant trends have been downsizing and refocusing on core business.

The contraction of corporate boundaries points to markets increasing their efficiency relative to firms’ administrative processes.

The turbulence of the business environment increased the costs of administration within large and complex firms and increased the need for flexibility and speed of response. Internet and PCs diffusion revolutionized market transactions.

Let’s shift our attention to the underlined corporate strategy within these issues. Vertical integration is a growth strategy through which a firm becomes owner of vertically related activities. The greater is the ownership over subsequent stages of the supply chain, the greater its degree of vertical integration. The extent of VI is indicated by the ratio of a firm’s value added to its sales revenue: the more a firm makes rather than buys, the greater its value added relative to its sales revenue.

There are different types of Vertical Integration: backward (or upstream) vertical integration, and forward (or downstream) vertical integration.

The benefit of VI are:

• Technical economies from integrating processes: the cost savings that arise from the physical integration of processes. (but doesn’t necessarily require common ownership!)
• Thus, vertical integration can avoid transactions costs.
• Superior coordination (firm’s system-ness)

We must look beyond technical economies and consider the implications of linked processes for transaction costs.

Let’s consider the value chain for steel cans, which extends from mining iron ore to delivering cans to food processing companies. The production between steel and steel strip is typically vertically integrated. While between steel strip and steel cans there’s  a very little vertical integration. The predominance of market contracts in this step is the results of low transaction costs in the market for steel strip: there are many buyers and suppliers are low.

Across steel production and steel strip production there is vertical integration essentially due to technical economies. These two processes use the same plants and the same knowledge, and the output of the first must fit the input requirements for the next stage, so these companies must invest in integrated facilities. In this situation a competitive market economy is impossible: each steel strip producer is tied to its adjacent steel producer. The market becomes a series of bilateral monopolies. There is no market price, because the price is set by bilateral negotiation between each producer and each supplier. It all depends on bargaining power.

This situation if regulated by market rules will lead to inefficiencies.

The culprits in this situation are transaction-specific investments. Within these steps both the producer must adapt their production to the needs of the other party. Each seller is tied to a single buyer which gives each the potential to hold up the other. This results in transaction costs arising from the difficulties of framing comprehensive contract and the risks of disputes and opportunism. The problem of hold up could be eliminated by contracts that fully specify prices, quality , quantities, and other terms of supply under all possible circumstances. The problem is uncertainty about the future, it is impossible to anticipate all eventualities during the contract period. Contracts are inevitably incomplete.

Internalizing a transaction imposes administrative cost. The size of this cost depends on several factors.

Differences in optimal scale between different stages of production

• Suppose you are a manager of FedEx, for your delivery service you require vans that are designed and manufactured to meet your particular needs.
• There is an incentive for FedEx to avoid the ensuing transaction costs by building its own vehicles
• Would this be an efficient solution? (discuss with the class)
• Almost certannly not: you will have inefficiencies due to the high fixed costs to set up  plant, you don’t have the knowledge, and you don’t have the critic mass required to set up all this investment
• Same is for brewery

Developing distinctive capabilities

• A key advantage of a company that is specialized in a few activities is its ability to develop distinctive capabilities in those activities.
• Technology based companies as Xerox, Kodak and Philips cannot maintain IT capabilities that match those of IT services specialists such as IBM and Accenture.
• The ability of these specialists to work with several customers stimulates learning and innovation.
• When one capability builds on capabilities in adjacent activities, vertical integration may help develop distinctive capabilities. Let’s think about IBM, that shifted from mainframe industry to IT service by developing distinctive capabilities.
• The key is the link between the set of capabilities

Managing strategically different business

• The latters problems are part of e wider set of problems. The management systems and organizational capabilities required for a manufacturing could  be very different from those required for another one.

The incentive problem

• VI changes the incentives between vertically related businesses.
• In a market mechanism the seller is motivated to ensure the buyer satisfaction. The buyer is motivated to secure the best possible deal.
• These are named high powered incentives
• With VI, the incentives are low powered
• You can fire someone who did the wrong thing, but you will do it when could be too late

Competitive effects of VI

• VI could be used to extend a monopoly position.

Flexibility

• Both VI and market transactions can claim advantage with regard to different types of flexibility.
• When you need rapid responsiveness to uncertain demand, there may be advantages in market transactions
• VI may also be disadvantageous in responding quickly to new product development opportunities that require new combinations of technical capabilities.
• Where the system-wide flexibility is required, VI may allow speed and coordination in achieving simultaneous adjustment throughout the vertical chain.
• VI is also a central theme of brand identity

Compounding risk

• To the extent that VI ties a company to its internal suppliers, VI represents a compounding risk insofar as problems at any one stage of production threaten production and profitability at all other stages.

But it all depends!

The idea of vertical  integration is the anathema to an increasing number of companies. Most of yesterday’s highly integrated giants are working overtime at splitting into more manageable, more energetic units – i.e., de-integrating. Then they are turning around and re-integrating – not by acquisitions but via alliances with all sorts of partners of all shapes and sizes. (Tom Peters)

The Scope of the Firms

“Strategy is a deliberate search for a plan of action that will develop a business’s competitive advantage and compound it. For any company, the search is an iterative process that begins with a recognition of where you are and what you have now” (Henderson, 1989).

There is a fundamental difference between Business strategy and Corporate strategy. The former is concerned with how a firm competes with a particular area of business, while the latter is concerned with where a firm compete.

In this regards, what the scope of the firm is?

The scope of the firm is defined by the corporate strategy and concerns the scope of the firm’s activities. We can identify three dimensions of the scope:

• Product scope: how specialized should the firm be in terms of the range of product?
• Specialized firms vs diversified companiesGeographical scope. 
• What is the optimal geographical spread of activities for the firm?
• Vertical scope. What range of vertically linked activities should the firm encompass?
• Vertical integration vs vertical specialization

Source: Grant, Contemporary Strategy Analysis

Our economy is frequently referred to as a “market economy”, in fact, it comprises two forms of economic organization. Market mechanism, where individuals and firms, guided by market prices, make independent decisions to buy and sell goods and services (“Invisible hand” of Adam Smith). Administrative mechanism of firms, where decisions concerning production and resource allocation are made by managers and imposed through hierarchies (“Visible hand” of Alfred Chandler). Firms and markets may be viewed as alternative institutions for organizing production.

The main difference between these organizations of the production is that the firms comprise a number of individuals bound by employment contracts with a central contracting authority. While, the market organization comprise a number of firms and individuals linked to each other by a set of contracts, without a central contracting authority.

If you want to renovate your house you can call a firm, or you may want to call a self-employed builder to undertake the work. He will probably subcontracted parts of the work to several professionals, plumber, electrician, joiner.. and so on. Firms and markets coexist, but their relative role vary. Let’s think about the mainframe computer industry and the personal computer industry. In the former the administrative mechanism predominates, while markets are more important in the latter. In mainframes IBM was the dominant supplier, it was highly vertical integrated, it produced many of its own components, developed its own operating system and softwares, and undertook distribution, marketing and so on.

PCs’ market by contrast involve a network of firms linked by market contracts: design and marketing are undertaken by HP, Acer, Lenovo, components are produced by Intel, Samsung, Assembly is operated by several unknown  to the public firms. Customer support is also outsourced to specialist suppliers often located in India and Eastern Europe.

What determines which particular activity is undertaken within a firm and which through the market? The relative costs!

Market are not costly, within the market organization you will encounter several transaction costs as: search costs, negotiation costs (see my article on negotiating a good price for rental car in us), monitoring costs, and eventually, arbitration and litigation costs. The intensity of these costs is determined by: the number of actors, the asset specificity, and, of course, bounded rationality (Herbert Simon) and information asymmetry (opportunism).

The comparisons between the set of transaction costs and the set o administrative costs of organizing within firms will lead the coordination of productive activities.

The three fundamental issues in corporate strategy could be well defined by these three questions:

1. Can the corporation create economic value by changing its scope? (Rent-generating opportunities).

2. Should activities be undertaken inside the corporation, or accessed through contracts, joint ventures, alliances, or other institutional arrangements?  How should the corporation grow?

3. How should the corporation be structured and managed to enhance the combined value of its individual business units?

Dear Italian, European and American friends,

Let's buy ourself debt! Why should we stay idle while our "enemies", our "competitors" (China, Arabia..) are buying our debt and our countries?!

Last week a man in Italy bought a full page on the top italian newspaper asking to the people to buy the italian bond to stop the debt crisis and the speculation around it.

The italian debt structure, 1,900 billion of euro, has an average maturity of 7-8 years. Every year 260 billion of euro arrive to maturity, that means that if every italian would buy 4,500 euro of debt every year this will entirely cover our financial needs!

I have re-done the computation, well in Italy we have 22 million of families, that means 12,000 euro of bond each to cover the financial needs. 

I am sure that not all the italian families have 12,000 euro to invest, but I am even sure that some families can invest more and some less, and we are not counting banks, institutions and companies.

I decided on myself to buy some bonds this week.

So, let's be patriotic.

Let's buy our debt!

We have contributed to debt growing every time we:

1. didn't pay all the taxes
2. worked out of the law
3. didn't work in the right way
4. didn't go to work because "sick"
5. took advantage of the public healthcare system even if we didn't need it
6. didn't pay the ticket on the buses 
7. voted the wrong politicians
8. didn't manage our garbage
9. ... 

Let's buy our debt, don't undersell your country!

Research in Peace

funny...very funny...and true!

Negotiation, Nudge and Anchor. How to obtain hundreds $ discount on a long-term rental car in US.

Theory defines the negotiation as a joint decision-making process between two or more interdependent parties, with preferences and interests of opportunistic nature and partially in conflict. This process can finish with an agreement.

Anchoring trap happens when you will estimate the magnitude of something by adding or subtracting a little from known magnitudes; so if you are in a town with 3 million you will calculate the population of the next town a bit bigger or smaller to yours. Anchors serve as nudges. We can influence the figure someone else will choose in a particular situation by ever-so-subtly suggesting a starting point for our thought process.

At the starting point of my experience in the United States I needed a car, I live outside Washington DC, the closest grocery store is 2-3 miles away and there is no public transport serving the neighborhood. So I started calling rental companies to find a good deal on a long-term rental car for the length of my stay in US. The lowest price they all said to me was around 850-900 $ per month, obtained negotiating without an anchor (and a Best Alternative). Then I started looking at the web, but the prices were around 750 $, then I found a deal on priceline.com for 650 $, but I had to go very far to take the car (around 100$ of cab…).

Then I tried to negotiate with this anchor with my first calls, and I discovered that when I called a previous 900$ rental agency saying I had an alternative for 650$ they lower their price close to that! So, as a good Italian, I started cheating!

I called the closest rental agency and gave them the anchor of 500$ and they lower their initial from 800$ to 510$, so I beat the priceline.com.

I used an anchor price to nudge the other negotiator.

Disagreeable Men Earn More Than Nice Guys

People who are disagreeable earn more than people who are agreeable, and the gap is biggest among men, according to an analysis of four surveys spanning almost 20 years. Men who are significantly less agreeable than average earn 18.3% more than men who are significantly more agreeable than average, while the comparable figure for women is 5.47%, says the study, led by Beth A. Livingston of Cornell University and presented at a recent meeting of the Academy of Management. Men's disagreeable behavior "conforms to expectations of 'masculine' behavior," the authors say.

Source: Do nice guys finish last? They certainly are a distant second when it comes to earnings