Vertical Chain

Vertical Integration

The degree to which the firm controls the chain.

Vertical Integration

Upstream Integration – towards raw materials

Vertical Integration

Downstream Integration – towards end customer

Boundaries of the Firm

The question for a firm is “Where to draw the boundary.” The answer is closely tied to material in CH 3.

Expanding is integrating

Contracting is outsourcing

Outsourcing• South Park – “They took our jobs”

http://www.gofish.com/userVideoPlayer.gfp?gfid=30-1015163

• Dell expanding in India - http://www.nytimes.com/2006/03/21/technology/21dell.html?adxnnl=1&adxnnlx=1143497181-q6B42De9MThtS0g2ZNxwqA

• The Dubai Ports deal. http://www.cnn.com/2006/POLITICS/03/09/port.security/

• A guide to best practice by Accenture: http://www.accenture.com/xdoc/en/services/outsourcing/ps/global/landing_ps.pdf

Should a firm vertically integrate?

Pros of doing it in-houseAvoid double markup problem

Upstream Firm: MC=10 and No Fixed CostDownstream Firm: P= 110-Q, MR=110-2Q Only cost to D is price set by U

Double Mark Up Problem

$/q

q

MCU

PD

MRD

What will MC to D look like?

Given a price set by U, what quantity will D buy?

Double Mark Up Problem

$/q

q

MCU

PD

MRD=PUMRU

So MRD=PU

MRU=110-4Q

What quantity will be traded?

How much will each firm earn?

Double Mark Up Problem

$/q

q

MCU

PD

MRD=PUMRU

PD = 85

PU = 60

QD =25

Profits U: 50x25=1250

Profits D: 25x25= 625

Double Mark Up Problem

$/q

q

MC

P

MR

Q =50

P = 60

with Vertical Integration

Profits: 50x50 = 2500

&

Consumer Surplus Increased

Other ways to Avoid Double Mark-up

Resale Price Maintenance: Up stream firm sets price that downstream firm can charge.

Manufactures Suggested Retail Price (MSRP).

Two-part Tariff

Should a firm vertically integrate?

Pros of doing it in-houseNo Hold Up Problem

ex: U invests ($5M) in equipment and training to produce component (MC= $1) specific to D.

The investment becomes a sunk cost for U.D could offer only $2 on 1M units. U would take it as it increases profits, but overall U earns a loss.

Therefore, U is hesitant of undertaking this investment.

Should a firm vertically integrate?

Pros of doing it in-houseMinimize Supply DisruptionsReduced ExternalitiesMonitoring QualityLower Contracting and Transaction CostsTaxes and RegulationCentralized Decision Making

Should a firm vertically integrate?

Pros of outsourcingFlexibleEconomies of ScaleSpecialized KnowledgeDecentralized Decision MakingFocus on Core Competencies

Integration vs Outsourcingchoosing along a continuum

Asset specificity, uncertainty, and the procurement decision

Other Vertical Relationships

Hybrid ArrangementsStrategic AlliancesLong Term ContractingJoint Ventures