Vertical Chain. Vertical Integration The degree to which the firm controls the chain.
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Transcript of Vertical Chain. Vertical Integration The degree to which the firm controls the chain.
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