Chapter 10: Vertical Integration and Scope of the Firm

Which two mechanisms is comprised by the capitalism economy?

*Market mechanism*: Individuals and firms, guided by market prices, make independent decisions on to buy and sell *Administrative mechanism*: Decisions concerning production and resource allocation are made by managers and carried out through hierarchies

Why is it beneficial to place two stages in a production process physically integrated close to each other?

*Technical economies*. Cost savings arising from physical integration of processes. (Explaining why it makes sense to put them physically together, but not ownership-wise) E.g. reduced transport and energy costs from putting production at the same location.

Which are 8 downsides of vertical integration?

- Differences in optimal scale between different stages of production - The need to develop distinct capabilities - Problems of managing strategically different businesses - Incentive problems - Competitive effects - Flexibility - Investing in an unattractive business - Compounding risk

Which are the two main benefits from vertical integration?

- Technical economies from the physical integration of processes - Avoiding transaction costs in vertical exchange

What types of vertical integration is there?

- Upstream/backward: into its suppliers' activities - Downstream/forward: into its customers' activities (Can also be full or partial)

What is the problem with the compounding risk related to vertical integration?

Vertical integration ties a company to its internal suppliers and internal customers. Problems at one stage in production would threaten production and profitability in all the other stages.

What is the problem with managing strategically different businesses related to vertical integration?

Managing activities that are strategically different is very hard, therefore most retailers don't manufacture. Management systems differ. Better to keep a focus and become specialised.

How does market transactions and vertical integration differ in flexibility?

Market transactions offer rapid responsiveness to uncertain demand, fast response to product development opportunities that require new combinations of resources and capabilities. Vertical integration offer speed and coordination in achieving adjustment in the vertical change, when system-wide flexibility is required.

What is the problem with different levels of optimal scale related to vertical integration?

One difficulty with vertical integration is that the firm might not have the possibility to produce the activity in such a scale that it would be worth it. Better to source it.

What is the problem with investing in an unattractive business related to vertical integration?

One disadvantage with vertical integration is that it might involve investing in an unattractive industry with low margins.

Which are the three main types of vertical relationships brought up by the book?

- Long-term contracts When one or both need to make specific investments, a long term contract can help avoid opportunism and provide security. But it has to anticipate future conditions, which is hard to do right. - Vertical partnerships When hard to specify long-term contracts, rely on trust instead. Provides security to support investments, flexibility, incentives against opportunism - Franchising Contractual agreement between business system and trademark. Bringing together the advantages of the firm (brand, marketing) with entrepreneurship and local knowledge

What is the problem with the need to develop distinctive capabilities related to vertical integration?

That the firm with potential to integrate another production stage would perhaps not be good at performing that activity. Someone else might be better at it.

How can one solve the problem with incentives related to vertical integration?

By opening up internal divisions to external competition (like Ericsson SPP competing with other management consultant firms about the project, keeping them at their toes)

What is the problem with the competitive effects related to vertical integration?

In a monopoly, there are no proven advantages in extending the monopoly across the value chain. Nothing to win. In a competitive environment, vertical integration means a risk of damaging the competitive position of the core business.

What are the recent trend in vertical integration?

Aiming for vertical relationships where combining flexibility and incentives of market transactions with close collaboration provided by vertical integration. -> Outsourcing not only commodities, but more complex products as well (IT services, payroll)

Why is it beneficial to own two stages in a production process?

Avoiding transaction costs. When there is many buyers and sellers at the market of a process, there will be market contracts, which is likely to be costly. Better then to avoid this.

What is the definition of vertical integration? How can the extent of vertical integration be measured?

A firm's ownership and control of multiple vertical stages in the supply of a product. The extent of it is indicated by the number of stages of the industry's value chain that it spans and can be measured by the ratio of its value added to sales revenue.

What is the problem with incentives related to vertical integration?

Vertical integration changes the incentives between the vertically related activities. When a market interface exists, both the buyer and seller ensure that the deal is good (*high-powered incentives*). Vertical integration creates internal supplier-customer relationships which have *low-powered incentives*.

What is a bilateral monopoly? In the context of vertical integration.

When two processes have technical economies, there is no competitive market between the two stages anymore. All relies on the bargaining power, which is costly, and encouraging opportunism and strategic misrepresentation.

What is transaction cost of markets? What is administrative costs?

Transaction costs: Costs of search, negotiation, drawing up contracts, and monitoring and enforcing contracts. Administrative costs: The corresponding costs for the activities when undertaking the activities within the firm.