Vertical Boundaries

Chapter 10 skillful boundaries Chapter 10 Vertical boundaries Aim of the chapter To infer the factors that influence the ways in which traffics on a vertical chain (value chain) should be/ be locate on the commercialize place brass instrument continuum. breeding objectives On completion of this chapter and the essential course session, you should cast a good understanding of the following terms and concepts execution chatter to political economy strategic calculation. Essential reading Buchanan, D. and A. Huczynski Organizational behaviour an introductory text. (London Prentice H alone, 2008) Chapter 18. Douma, S. nd H. Schreuder Economic progresses to organisations. (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 social cost, Journal of lawfulness and Economics 3 1960, pp. 144. Grossman, S. and O. stag The cost and benefits of give birthership a sche me of vertical and lateral integration, Journal of Political Economy 94(4) 1986, pp. 691719. Williamson, O. E. The economics of organization the transaction cost approach, Ameri deal Journal of Sociology 87(3) 1981, pp. 54877. 10. 1 IntroductionAs noted in Chapter 1, we may regard the basic unit in organisational abridgment as an exchange or transaction generated in the division of labour. The division of labour (exogenous/endogenous Chapter 3) creates value or vertical chains for example as shown in Figure 10. 1(a) running from crude oil extraction to the retailing of petroleum products. We in a flash operate at the aim of organisations or pisseds (recognising that at a greater level of disaggregation the points in the chain are also based on chains of the division of labour) and pose the chief as to where their boundaries should be located on the value chain.In fact the picture is commonly more than complex than the one depicted in Figure 10. 1(a). Activities usually dep end on inputs at all points down the vertical chain, as depicted in Figure 10. 1(b). So organisations or market place exchanges could lock and coordinate each of these transactions. Furthermore, some of these inputs may be common to the points on the main chain (see Appendix 1. 2 in this guide), want accounting services, in which case the picture looks more like Figure 10. 1(c). Note the use of di-graphs once again. 91 government supposition an interdisciplinary approach a) Oil extraction Refining Retailing (b) Shipping or pipe Distri justion (c) Accounting Figure 10. 1 In general we are asking the question as to whether a particular transaction should be internalised ( distinguish) or left in the market (buy), as depicted in Figure 10. 2 that is, whether a point on the chain should be a department/ function or division or remain independent. For the moment we restrict our attention to this simple choice rather than the more elaborate posture on the marketorgani sation continuum.We shall return to the more elaborate issue later on. Market (Price machine) Figure 10. 2 Start by asking what the benefits and costs of using the market magnate be. The benefits could include the following Independent firms may be able to reap the benefits of economies of scale (i. e. operate at an output that minimises unit costs) whereas internal departments may not. Unless the firm itself can absorb all the efficient output of the department, it must either operate below the optimal output level or sell on to another firm.This readiness compromise any information advantages of the purchasing firm (see below). Independent firms are more subject to market disciplines than departments and may hold down costs they can control more effectively. Costs may be difficult to identify in departments. Firms might, though, attempt to bend market incentives inside organisations. Tapered integration refers to a situation where a firm is supplied partially by an indepen dent firm and partially by its own department. This grants their relative cost structures to be compared. Independent firms (i. e. their managers) may have stronger incentives to innovate when compared with managers of departments. shaping 92 Chapter 10 Vertical boundaries The costs of using the market might include the following Private information may be leaked to independent firms particularly if there is a need to share technical information. The focal firm becomes to a tip dependent upon an independent supplier (depending upon switching costs).Thus the latter has a proponent resource (see Chapter 6) and may use it to hold up the focal firm. It may prove difficult to control and co-ordinate flows of goods and services down a vertical chain of independent firms. This may be particularly so where there is a need to fit the products closely. Just-intime methods seek to overcome this problem and permit independent firms a great deal with long-term relational fills (see b elow). The way most economists (following Coase and Williamson) call back about the choice amidst a market and organisational exchange/transaction is entirely predictable choose the arrangement that minimises costs. The foot here is to ntroduce the idea 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 both outturn costs (which relate to technical efficiency) and transaction costs vary between organisational transactions and market transactions, hence the total costs should be minimised. Activity immediately read Sections 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 salutaryy informed, rational actors where catching is complete, there are no transaction costs and the choice between market and organisational exchange is of no consequence (at to the lowest degree as conceived at bottom this framework) unless production costs vary (which, again, they should not under the very(prenominal) self-assertions). It is because we relax both the assumptions of adequate rationality and full information in the context of real markets that transaction costs arise and the choice between market and organisational transaction is pertinent.Transaction costs theory is used both in a normative and corroborative sense. The new assumptions are as follows Individual bounded rationality people are by choice rational but limitedly so. Individuals are neither able to make very complex calculations nor to assimilate large amounts of information. As you might expect, sociologists tend to like this assumption they see it as more realistic than the full assumptions of rationality. Opportunism individuals are not only self-interested but behave with guile.For example, in the context of punt theory, individuals testament issue promises which are not credible, make use of asymmetric information and they cannot be wanted. Contracting about transactions is neither because of inherent uncertainty and incomplete information. Contracting can thus lead to ex ante opportunism (namely, adverse selection) and ex post opportunism (namely, moral hazard). These hazards will be exacerbated to the degree that there is little choice of transacting partners and therefore reputations (see Chapter 7) in respect of third parties will not constrain opportunism small numbers exchange. 3 Organisation theory an interdisciplinary approach Anticipated repeated interaction will make reputations important to both parties but if in the process there is knowledge by doing, it is then costly to later switch exchange partner. Williamson (1981) calls this the fundamental transformation it ties the parties into the relationship. Williamson also observes that parties to a transaction might hav e a gustatory sensation for a certain type of transaction in addition to the costs and benefits. He calls this nimbus. In effect Williamson is introducing wider motives/utilities.Although the vocabulary introduced by Williamson is rather frighten off at first sight, it has the advantage that it should link your thoughts into many of the ideas you have already encountered. Activity esteem of transactions as a captives predicament or trust game. Both parties would like to let to contact Pareto efficiency but each is wary of the other and in the absence of some mechanism to offset this wariness, the exchange does not materialise the Nash equilibrium. So what mechanisms are available? You should be able to list the mechanisms.They can be derived as follows. Competitive market the price as a sufficient statistic here the prisoners dilemma does not model the situation. Organisation three possible mechanisms which can give rise the Pareto-efficient outcome rather than the Nash equilibrium are 1. Authority and power. 2. Trust (cultural mechanisms). 3. Repeated transaction and reputation effects. As we have seen in earlier chapters, alongside observe and employment nips (incentives), we expect organisations to avail themselves of a mixture of these mechanisms.But note, if we mobilise in terms of real markets rather than the ideal type of perfect markets, then the price mechanism is not sufficient and perhaps these mechanisms might also apply at different 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 impact upon the transaction costs.Activity like a shot read Section 8. 3 in D and S. The argument is that asset specificity (sometimes called relation-specific assets), uncertainty/complexity and frequency of exchange all increase the likelihood th at a transaction will be placed (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 communication costs physical asset specificity e. g. pipeline delivering crude oil use 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 now have a predictive theory about vertical integration and, incidentally, contracting out. By and large, empirical evidence has supported transaction cost theory particularly the impact of complexity in the context of uncertainty though one should bear in mind what Williamson terms atmosphere.If there are widespread specific preferences for instance, managers might prefer the power implied by organisation this would complica te 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 across different national tax regimes may perplex it an advantage to contract out. An organisation might vertically integrate to gain a monopoly or go 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 formal approach to Williamsons reason out. The transaction costs approach still leaves plain-spoken two questions 1. Will the integration, if appropriate, be backwards or forwards? 2. What type of organisation e. g. centralised or decentralised hierarchy? (I leave an answer to this question to Chapter 12. ) An extension of t ransaction costs theory called property rights theory (which is not covered 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 bargaining power. Incomplete contracts mean that residual extra-contractual control of assets is important. Ownership confers bargaining power over useable decisions when enforceable contracts break down.Anticipation of post-contractual hazards determines earlier thronement decisions. We now 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 re sighted. 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 respondent 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 Spot markets (perfect competition) Real markets Bargaining Franchising Long term contracts (network organisations) Tapered organisations Virtual organisations Alliances Joint venture Monopoly (small numbers) Externalities Asymmetric information Fixed cost ( happen to supplier) Risk share-out 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 o f 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. Here we recognise that in the real world the market environment is often far from perfectly competitive. If the transaction is left to the price mechanism, then various market distortions may cave 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) change organisations to engage in a protracted relationship. They often occur between buyers and su ppliers 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. Between these two extremes, risk-sharing contracts can be designed.If the buyer and supplier have differing risk preferences then, other things creation equal, an optimal contract can be found. Network and practical(prenominal) organisations (see B and H) are usually based upon long-term relational contracts, as are alliances. Joint ventures imply comeliness 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? (T he normative question. Alternatively, where is it placed and why? (The positive 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 acquiring information transaction costs residual property rights market imperfections regulation.But how are these various strands to be interweave together? Unfortunately there is, as far as I am aware, no embracing theory. B and H introduce you to the concept of bodily strategy and to what many organisation theorists term strategic choice. Although the idea that organisational arrangements designed to control and co-ordinate activities are a matter of choice was first introduced by s ociologists 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 encourage you to think in these terms even if you want to question the restrictive 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 formulation 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 back uped competitive advantage (SCA) . Why do some firms/organisations manage to sustain a better performance than their competitors, eon 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 find 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 advantage, for whatever reason, then this implies that perfect competition is not operating. In so far as those running organisations seek SCA, they are nerve-wracking to undermine 97 Organisation theory an interdisciplinary approach competitive forces.The early sections of D and Ss chapter show h ow game theory is an native 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 anticipates 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 find contingencies not covered by the contract. By making the investment, S in effect confers bargaining power upon B who may e ven use this power to renegotiate the original contract (attempt to reduce the price of the good or service exchanged).S will then anticipate these moral hazards and accordingly 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 find a Nash equilibrium rather than the Pareto-efficient outcome. So what can be done 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 joint 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 fro m the Nash equilibrium to the Pareto outcome). But let us continue to assume 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, flexible 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 needs 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 needs 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.Wi th 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 innovate in order to reduce costs. Clearly, B wants S both to innovate 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 which 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 leakage 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 household 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 clause also produce repeated interaction (the Japanese 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 ad vantages 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 > > R S B Long-term contracts > > R S B Organisation twain of co-ordination = 3 > > 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 you some appreciation of how to analyse organisation choices from a genuinely st rategic 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 understanding of the following terms and concepts transaction cost economics strategic calculation. Sample examination question 1. Explain why a transaction should be placed in a market or an organisation. century