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Vertical Boundaries of the

Firm

David Hennessy

Economics Department

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1Flow of Production

The production of a good or service

often requires a wide range of

activities organized in a vertical

chain.

Production flows from upstream to

downstream, e.g., pork,

automobiles.

Illustration: winemaking (slide).

A value chain (graph).

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3

The Firm and the Value Chain

Which portions of the chain should

the firm be involved in? What is it good (bad) at? Where to

draw boundaries, and when to

change them?

Should a firm make or buy?

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4Questionable Assertions

A: A firm should buy to avoid the costs

associated with making.

B: A firm should make in order to capturethe profits due to the input producer.

C: A firm should make in order to assure

supply and avoid fluctuating prices as

demand and supply conditions in theinput market change.

There are many such rules of thumb.

Their merit?

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5

Some Definitions The value chain: This is the process

which begins with the acquisition of raw

materials and ends with the distributionand sale of finished goods.

Segment value added: This is the

revenue associated with that segment of

the chain (graph).

Upstream (downstream) activities: These

are activities occurring early (late) in the

value chain.

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6More Definitions

Support activities: These are activities not

directly associated with the transformation

of products in space, form, or time, but still

essential to the operation of the business.

Transfer price: This is a price used within a

firm that is used for pricing goods as they

move along segments of the value chain inwhich the firm operates. (uses in intra-firm

make/buy decisions and in tax issues).

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7Make or Buy?

Make relates to internal production.

Buy relates to use of the marketplace.

Reasons to buy:a) economies of scale and scope,

b) market discipline.

Reasons to make:a) coordination,

b) transactions costs,

c) information leakage.

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8Reason to Buy: Scale/

Scope Economies

If the firm makes, it may not be

able to achieve the economies ofscale/scope that a market supplier

achieves.

The market supplier may havecritical mass (graph).

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9Critical Mass

Key point: AC falls from Q0to Q*

Average

Cost

Q0

AC0

Q*

AC*P

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10Graphic Representation: Scale

Economies Suppose your firm needs Q0widgets,

and that many other firms also need

widgets.

The market firm can sell to many firms,and it sells Q* to make average costs

very low (AC* rather than AC0).

The market firm can sell a widget at

price P with AC0> P > AC*

, and stillmake a profit.

Who benefits from the trade?

If all firms that needed Q0produced Q*,

then who would use the surplus?

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11Scope Economies

Example: Calculators and watches.

Reason: The costs of developing and

producing the common liquid crystal

display can be spread over more output.

Other examples? Sales in Sears vs.

specialist stores. Boeing does airplanes

and aerospace. Proctor and Gamble.

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12Cost Function and Scope

Economies

Let the cost of producing Q1 watches and

Q2calculators be function C(Q1, Q2).

Produced separately, they cost

C(Q1, 0) + C(0, Q2).

Produced by the firm, they cost

C(Q1, Q2).

What if

C(Q1, 0) + C(0, Q2) > C(Q1, Q2)?

What if the reverse is true?

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13Cost Function and Scope

Economies, Contd If your firm needs only calculators as an

input, then to compete cost-wise with a

firm producing both you may have to

produce watches too.

But you know nothing about the watch

business, and dont want to.

Punchline: Buy from the market, and

avoid the distraction.

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14Origins of Scale Economies

Adam Smith said they came from the

division of labor.

The pin factory: three tasks to do;

a) make the head

b) make the spike /

c) solder them together

He found (observation) that it was less

efficient to let three people do all three jobsthan let each specialize in one of the tasks.

Another example: legal specialization

(graph).

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15Specialization Among Lawyers

AC

Number of Lawyers in the Market

AC

General Practice Lawyers

ACPatent Lawyers

Specialization is efficient

Specialization

not efficient

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16Reason to Buy: Market

Discipline The market firm may produce only one good,

focusing on the costs and quality of that

product.

If a firm producing other stuff decides to makean input, then it may be for hard-to-explain

reasons (to be discussed later).

It may then be difficult to ascertain whether

the decision to make was wise.

Some insights may be obtained from agency

theory.

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17The Agency Concept

Defn: An agent is an economic entity underformal or informal contract to provide

resources, services, or goods to another

economic entity (the principal) in return for a

(possibly outcome or environmentdetermined) reward.

In the firm, the agent is generally the

employee, and the principal generally the

employer.

The employer must guard against slack work,

and the abuse of resources for ends other

than those of the employer.

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18Agency Costs

Defn: Agency costs are costs

which accrue to the principal that

are associated with insufficient orinappropriate activities by agents,

and also the costs of guarding

against such activities.

Two examples;

a) Influence costs,

b) Innovation problems.

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19Influence Costs

Suppose a firm decides to produce an input

because no market firm can be trusted to

produce precisely what is needed, e.g. specific

software.

Now you have employees who know moreabout this input and its importance to the firm

than anyone else in the firm.

Later, suppose you want to reassess the

decision to make. Who do you turn to? The

most knowledgeable employees have anagenda that differs from that of the employer.

They can not be relied upon, they may fudge

the data. This is the principal-agent problem.

Case of unions and operations manuals.

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20InnovationCosts The firm wants to be rewarded for

successful innovations/research.

Suppose a good scientist innovates and is

rewarded with a promotion. If he/she

resigned and set up a company to exploitthe innovation, the profits might be

enormous. The firm will have to pay well to

prevent this (agency cost).

The scientist could also change jobs,

carrying the innovation. The company will

have to monitor to prevent such theft

(agency cost also).

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21Reason to Make: Coordination

To produce a complicated product

cheaply, many people have to

successfully make interrelated

decisions about many resources. It isoften easier to coordinate activities

when important inputs are made inside

a firm.

Example: a restauranteur who needs

waiters and chefs to coordinate. Best

to hire nightly longer-term?

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22Types of Coordination Costs

Time: Release movies on time after

advertizing, software, microchips, books

(on death of celebrity).

Size: The space shuttle disaster of 1986

may have been caused by an ill-fitting O-

ring.

Color: Benetton needs the colors it uses tobe fashionable at the time.

Sequence: Coordinating sequence is vital

on assembly lines and in sports.

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23Reason to Make: Transactions

Costs There are costs associated with

organizing and transacting exchanges

between arms-length firms in themarketplace..

Such costs include negotiating, writing,

and enforcing contracts. Consumes

expensive management time.

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24Reason to Make: Information

Leakage Firms usually have sensitive private

information concerning innovations, sales,

strategies, financial status etc.

Employers may be easier to keep quiet than

outside firms who might have to be given

access to this information to do their job.

Examples: Coke and its secret formula;

mining firms use their own geologists;

Chinese Wall.

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25Assertions T/F?

A: A firm should buy to avoid the costs

associated with making? Depends on

price, quality and other issues.

B: A firm should make in order to capturethe profits due to the input producer?

Depends on cost structure etc.

C: A firm should make in order to assuresupply and avoid fluctuating prices?

Might a production contract or use of

futures markets (buying price stability) be

less costly?