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?