CHAPTER 19 VERTICAL INTEGRATION AND OUTSOURCING CHAPTER SUMMARY This chapter analyzes the vertical boundaries of the firm. It begins by defining the vertical chain of production. The benefits of acquiring inputs through competitive markets (when they exist) is stressed. Reasons for nonmarket transactions (vertical integration and long-term contracting) are introduced. The choice between long-term contracts and vertical integration is analyzed with attention focused on the importance of firm-specific investment in affecting this decision. Other major topics include: choosing the length of a contract, contracting with distributors, and recent trends in outsourcing. The appendix provides a more detailed example of how ownership rights can affect investment incentives (in this case, investments in effort). CHAPTER OUTLINE VERTICAL CHAIN OF PRODUCTION Managerial Application: Long-Term Contracts Managerial Application: Vertical Outsourcing by Taiwan Semiconductor Managerial Application: Outsourcing Logistics BENEFITS OF BUYING IN COMPETITIVE MARKETS Managerial Application: Merck and Astra Joint Venture Managerial Application: Made in the USA REASONS FOR NONMARKET TRANSACTIONS Contracting Costs Firm-Specific Assets Managerial Application: Kodak-IBM Outsourcing Renewal Measuring Quality Controlling Externalities Extensive Coordination Market Power Managerial Application: Price Discrimination and Antitrust Law Taxes and Regulation Other Considerations VERTICAL INTEGRATION VERSUS LONG-TERM CONTRACTS Incomplete Contracting Ownership and Investment Incentives Managerial Application: Contracting Problems and Investment Incentives Evidence from China Managerial Application: Renting and Asset Abuse Specific Assets and Vertical Integration Managerial Application: Owning versus Leasing Networks 19-1
Managerial Application: Lease versus Buy Managerial Application: Vertical Integration in the Aerospace Industry Asset Ownership Other Reasons Continuum of Choice CONTRACT LENGTH Managerial Application: Short-Term Leases Managerial Application: Divorce between Outsourcing Partners CONTRACTING WITH DISTRIBUTORS Free-Rider Problems Advertising Provisions Managerial Application: Conflicts over Advertising Provisions Exclusive Territories Managerial Application: Conflicts over Exclusive Territories Academic Application: Company Ownership versus Franchising Double Markups Example Two-Part Pricing Quotas Regulatory Issues RECENT TRENDS IN OUTSOURCING Managerial Application: The Politics of International Outsourcing SUMMARY APPENDIX: OWNERSHIP RIGHTS AND INVESTMENT INCENTIVES Basic Problem Ideal Effort Choices Actual Effort Choices under the Contract Vertical Integration Optimal Organizational Choice 19-2
TEACHING THE CHAPTER This chapter builds on the profit-maximization analysis presented in Chapters 5 and 6, and the price-discrimination analysis of Chapter 7. The chapter begins by presenting the quantitative analysis of vertical integration but also includes numerous Managerial Applications that can be used to illustrate the key points and generate class discussion. Figure 19.5 provides a good summary of the factors that affect whether a firm obtains assets in the market or chooses to vertically integrate. Students should be quite interested in the section on outsourcing since it is a topic that is frequently in the news. The associated Managerial Application should generate good class discussion. The appendix presents additional coverage of the topic, including a final Analyzing Managerial Decisions scenario. The main concepts of the appendix should be accessible for all students, however those students with a more advanced mathematical background will be able to follow the quantitative analysis as well. There are only a few questions that allow students to practice the quantitative analysis presented in the chapter. The Self- Evaluation Problems offer some practice, but the Analyzing Managerial Decisions scenarios present more opportunity. The Review Questions focus more on the core concepts of the chapter than quantitative analysis. There are four Analyzing Managerial Decisions scenarios in this chapter. The first scenario, BioChem Pricing Policy is a quantitative analysis of BioChem s production decision. Students are asked to find the optimal prices to maximize profits and are then asked to consider how vertical integration could help achieve this pricing policy. The second scenario, Oil Industry Distribution Systems asks students to evaluate the difference between direct-serve gas stations and those served by distributors. This scenario is a relatively straightforward application of the material and is not quantitative in nature, but students must have a good grasp of the factors that affect this decision to be able to fully answer the questions. The third scenario, AutoCorp is an even more comprehensive scenario since it involves both a quantitative analysis and a discussion of the key concepts in the chapter. The final scenario, Insurance Industry Distribution Systems, is located at the end of the appendix for the chapter. All students should be able to evaluate this scenario even if the quantitative analysis of the appendix was not covered in class. (See the Solutions Manual for the answers to these problems). 19-3
REVIEW QUESTIONS 19 1. Discuss the pros and cons of the policy described in the following quote from Fortune: 1 According to the new thinking, any kind of work to which a company can't bring a special set of skills should be spun off, outsourced or eliminated. Thus AT&T, GE, IBM, and Shell Oil are in the process of spinning off legal, public relations, billing, payroll, and other services. What's left, whether it's a $100 million corporation or a $100 billion corporation, is the ideal size.... For example, if marketing is a competitive advantage in an industry, then it should build up its marketing muscle and employ outside suppliers and service firms to do everything else. There are advantages of outsourcing, for example, that might come from economies of scale and scope. For instance, IBM might be able to provide computer services to Kodak at a lower cost than Kodak could provide the services in house. Companies, however, should be careful not to outsource too many activities. One primary concern is the investment in specific assets. Specific investments can motivate important contracting problems that can make vertical integration the desired alternative. The quote seems to ignore contracting problems. Contracting problems also might arise due to fears of sharing proprietary information with outside companies. Following the advice in this quote is likely to lead to too much outsourcing. 19 2. The Black Diamond Company mines coal. It would like to build a processing plant right next to its major mine. The location of this mine is relatively remote and is not near other coal mines. Tax considerations, as well as government regulations, dictate that the processing plant be owned and operated by some independent company (other than Black Diamond). Your company, the Greg Norman Coal Company, is considering building and operating the plant for Black Diamond on a contract basis. Your job is to negotiate the contract with Black Diamond. Discuss the terms that you will try to get Black Diamond to agree to in the contract. Explain why these terms are important to you. 1 1 B. Dumaine and J. Labate (1992), Is Big Still Good? Fortune (April 20), 50. 19-4
Building the processing plant will place you in a tenuous position. The investment is very specific and the Black Diamond Coal Company will have incentives to lower agreed upon prices for processing after the plant is built. To reduce this potential problem, you probably want to negotiate a long-term contract (e.g., 30 years). Short-term contracts will place you in the undesirable position of having to renegotiate with Black Diamond who is likely to have a strong bargaining position given your investment is sunk. You also want to include relatively detailed provisions on prices, price changes, etc. These provisions will help you in potential litigation. You might also want to restrict Black Diamond from dealing with other processors (or have some minimum volume of coal that it must commit to your plant). This provision will limit Black Diamond's threat to deal with other processing plants if you do not reduce prices. 19 3. Evaluate the following quote: The major advantage to outsourcing is that it reduces a company's capital costs, freeing the company to use scarce capital for other purposes. This claim is questionable given the existence of well-developed capital markets. Having some other firm produce a product does not reduce investment, it simply shifts the capital expenditures to another firm. Buyers still pay for this investment through the price of the product. The important question is whether more value is created by producing the product internally or externally. If internal production is more valuable, the firm can raise money in the capital market for financing the relevant assets (capital is not scarce for "good projects"). If external production is more valuable, funds can be raised by the supplier. 19 4. In explaining the recent acquisition of a supplier, an executive made the following argument: We purchased the supplier so that we could keep the profit rather than pay it to some other firm. Evaluate this argument. This argument is dubious. It is in the economic interests of the two firms to choose the ownership structure that maximizes value. This value can be split in any way by adjusting the price of the product. If more value is created by outsourcing, the firm can demand a price that gives it at least the same profits. It shares in the additional value that is created by choosing an efficient organizational arrangement by negotiating a lower price. 19-5
19 5. Cable television companies lay cables to individual households in the communities they serve to carry the television signal. How specific is this investment? What kind of arrangements would you expect the cable companies to make with local communities about the pricing and taxation of cable services? Explain. This investment is highly specific; in its next best use the value of the cable is greatly diminished if not useless (no other product could be transmitted over the cable; phone lines already exist). The difference between the cable s current value and its next best use value is its quasi-rents. Thus the quasirents are extremely high and you would expect strict contractual arrangements between the cable company and local community subscribers to prevent ex post contractual opportunistic behavior by both parties. The cable company might increase subscription costs to capture these rents as subscribers have no other cable TV alternative (they would be forced to watch only channels 1 13). Cable companies will also charge additional flat fees for special channels and pay per view options for viewers addicted to cable. Conversely, local communities have the power to raise taxes on local industry. Once the cable has been installed taxes could be raised to capture the quasi-rents. The cable company will be forced to pay as their cable is useless for anything else. They wouldn t dig up or take down the cable and go to another town. Thus, you would expect strict regulation of the cable industry prices can t be altered much and taxes can t be changed. If either party breaks the regulation they would rely on the courts to settle the dispute or implicit market behavior. (Example: If the cable company increases rates, the next town they go to will require them to pay more in taxes.) 19 6. The Hidden Dog Fence company sells invisible electric fences to contain dogs within yards. For a half-acre lot, the cost is $2,000 for the system and installation. The market for invisible dog fencing is competitive: Several companies sell similar products at about the same price. In each case, the dog wears a batterypowered collar. The collar give the dog a shock if it gets near the boundary of the property. Hidden Fence uses a specially designed collar that uses batteries made specifically for Hidden Fence by the Battery-O-Vac Company. The batteries last for 3 months and cost $25 apiece. Hidden Fence has a patent on these batteries, and there are no alternative source of supply. Other fence companies produce products that use generic batteries. Currently, the battery costs of these other systems are the same as for Hidden Fence. 19-6
a. Suppose that you purchase the system from Hidden Fence. After you purchase the system, how much will Hidden Fence be able to raise the price of its batteries before you discontinue use of the system and buy a different system from another company? (Suppose that you do want to maintain an invisible fence.) For this question, assume a 10 percent annual discount rate, no inflation, and an infinite life for the invisible fence, yourself, and the patent for the batteries. A new system from another company will cost you a present value of $3,000. This includes the $2,000 initial investment and the present value of the battery costs ($25/.025 = $1,000). The initial investment of $2,000 in the Hidden Fence system is sunk. The price of the batteries can thus be raised up to the point where the present value of the cost is $3,000. To calculate this price, solve the following equation: P/.025 = $3,000 = $75. So the company can raise the price of batteries up to $50. b. As the management of Hidden Fence Company, what might you do to convince a worried prospective customer that opportunistic behavior with respect to battery prices is not a likely occurrence? The company can try to convince you that they will not do this because it will harm their reputation. They can stress that it acting opportunistically will make it difficult for the to make future sales. They might also give you a contractual guarantee to sell you batteries at $25. 19 7. Advanced Interconnect Manufacturing Inc. (AIM) is an independent company. It is located in the Elmgrove plant at Kodak. It was formerly owned by Kodak, but was purchased by five managers (with the help of outside investors). AIM assembles wire harnesses for use in machines such as copiers and X-ray machines. The vice president of the company claims that the company is more efficient because, as an independent company, AIM doesn t have to share any of Kodak s corporate overhead. As he notes, Kodak s CEO doesn t get paid by us. a. Evaluate the vice president s explanation for the increased efficiency of AIM since the ownership was changed. The accounting profits of AIM might be higher without an allocation of overhead from the central company. However, this does not mean that the company is more efficient. Kodak s CEO is paid either way and no obvious value is created by shuffling the accounting of this payment. 19-7
b. Give an alternative explanation for the increased efficiency. The managers might be more efficient under the new structure because they are owners. Typically, owners have more incentives to increase value than employees. 19 8. Jimmy s Stereo Company manufactures stereo equipment. Its business strategy is to provide retail customers high-quality equipment, along with good service and warranty protection. It currently distributes its products through licensed dealers who have exclusive territories. Discuss: (1) why Jimmy s might offer its distributors exclusive territories, (2) the potential problems that this policy might create in terms of retail pricing, and (3) potential policies that Jimmy s might use to address this pricing problem. (1) Distributors can have incentives to free ride on the brand name and provide suboptimal sales efforts (for example, insufficient expenditures on advertising and other inputs). One of the most common methods of reducing free riding is to grant exclusive territories in a given market area. By giving distributors monopoly profits for a specific market area, there are fewer incentives to free rid, since the distributors internalize more of the benefits from their sales efforts (fewer benefits go to other units not owned by the distributor). (2) Granting distributors monopoly power over specific market areas creates successive monopolies and the double markup problem. Since both manufacturer and distributor face downward sloping demand curves each has the incentive to mark up the product s price above cost. The end result is too high of retail price and too low of quantity sold relative to the profit maximizing solution. Overall the company suffers from reduced profits. (3) To potential methods of solving the problem are two-part pricing and quotas. With two-part pricing the distributor is charged an up-front fee to transfer some profits to the manufacturer. The manufacturer then sells the product at marginal cost. The distributor, in turn, has incentives to choose the output than maximizes system-wide profits (where true marginal cost = marginal revenue). A quota would required the distributor to sell at least the profitmaximizing output level. 19 9. BQT Manufacturing produces electric lamps. To produce these lamps, BQT must either make or acquire bases for the lamps. Currently, the company outsources the production of the bases for their lamps to the ACE Lamp Company. BQT maintains ownership of the machinery that is used to produce the bases. ACE uses BQT s machines at plants owned by ACE. a. Why do you think BQT is subcontracting the production of the bases? 19-8
Presumably, value is created through subcontracting. For instance, ACE might be able to produce the bases more cheaply than BQT could because of economies of scope or scale. b. Why do you think BQT maintains ownership of the production equipment? Presumably, the production equipment is firm specific. There would be a potential hold-up problem if ACE owned the equipment. BQT owning the equipment reduces this problem. If ACE tries to raise their price BQT can take the equipment and use it elsewhere for producing the bases. If BQT tries to lower the price to ACE, ACE can refuse the offer and not be stuck with firm-specific equipment. c. What problems might be caused by BQT s maintaining ownership of the production equipment? One major problem is maintenance. Since ACE does not own the equipment they are likely to have improper incentives to maintain the equipment. d. What might BQT do to reduce the magnitude of these problems? The contract might call detail the maintenance requirements for the equipment. One way to monitor the maintenance under the contract is for BQT to station some of its employees at the ACE plant. 19 10. Most of the McDonald s restaurants in the Rochester area are owned by one individual. Discuss why this ownership pattern makes economic sense. First, there might be productive efficiencies from owning multiple units in the same area. For instance, the owner might be able to negotiate one supply contract for all its units with an input supplier rather than have separate owners negotiate multiple contracts. Second, the ownership pattern can have important incentive effects. There are likely to be significant externalities among the units within a given area. For example, if one unit advertises on the local radio some of the benefits will go to other units in the area. Under multiple ownership there will be insufficient investment in these activities due to free-rider problems. Single ownership internalizes these externalities and helps to promote efficient investment. 19-9
19 11. You are at a cocktail party, where you meet a CEO of a pharmaceutical company who has been thinking recently about her overseas distributors who have exclusive sales territories. She can't quite figure out what is troubling her, but she is dissatisfied with these distributors. You describe the double markup problem. The CEOs eyes light up. You are exactly right, she says. The distributors are setting prices for our product that are too high. A year passes. You meet the CEO at another party. She heads straight for you and says, You were wrong. There was no double markup problem. After our talk a year ago, I terminated the contracts with all our overseas distributors. I sent our own people overseas to set up in-house distributors. To motivate the region managers I tied a big part of their compensation to the profitability of their regions. I was sure I would see a big change, but overseas prices are just about the same as they were when we used exclusive distributors. I guess prices weren't that bad with the distributors. Do you think the CEO's conclusions are correct? Why or why not? The double markup problem does not go away simply because you place the transaction inside the firm. Given that the managers are compensated on regional profits there is still an incentive for them to markup products beyond the optimal amount. 19 12. The Boswell Medical Center is the only hospital in a rural community. It requires significant janitorial services to clean its buildings and equipment. It also requires a relatively large lab for conducting tests of various types (for example, MRIs, blood tests, ultrasound tests). Do you think that Boswell is more likely to outsource its janitorial services or lab work? Explain. Boswell is more likely to outsource the janitorial service for several reasons. First, the assets are likely to be less specific than for the lab. Boswell is the only hospital in the area. Thus, much of the investment in equipping, staffing, and setting up the lab is likely to be specific to Boswell. Owning the lab reduces the potential hold-up problem associated with this specific investment. Second, it is likely that it will be easier for Boswell to measure the quality of the janitorial services than the lab work. Thus it will be easier to address the agency problem of the subcontractor trying to cut costs at Boswell s expense. Finally, to the extent that there are other companies in the area that might use janitorial services (other than hospitals) there may be some benefits from economies of scale (from having a large janitorial company serving multiple businesses). 19-10
19 13. The Hanson Clinic is a well-regarded medical center located in a semirural area in the Midwest. One of its specialty areas is treating rare forms of cancer. To support this activity Hanson wants to construct a new lab. The lab will require very specialized equipment, a specially designed building, and a skilled staff. The estimated cost of the equipment and building is $50 million. The Clinic is considering three possible organizational arrangements. The first is vertical integration. The second is outsourcing (where another company constructs the building, purchases the equipment and provides contractual services to the clinic). The third is for the clinic to purchase the equipment and building, and lease them to an independent operator (who would provide contractual services to the clinic). Discuss the pluses and minus of each of the three alternative structures. What factors do you think are most important in making this choice? Pluses Minuses Integration Low holdup problems Possibly have more control over quality of production (independent contractor will have some incentives to shirk on quality). Low-powered incentives for lab manager to care about costs, etc. Outsourcing High-powered incentives for the lab manager to cut costs and be efficient. Hold-up problem. Might shirk on quality. Leasing Relatively low hold-up problem. High-powered incentives for the lab manager to cut costs and be efficient. Low incentives for the lab manager to maintain the equipment. Might shirk on quality. Relevant factors are: (1) do the firms have incentives to honor contracts and not engage in hold-ups? If so, it will tend to favor outsourcing. 19-11
(2) Is it easy to observe whether the equipment has been maintained? If not, the leasing option is probably not very good. (3) What is the level of uncertainty? Higher uncertainty makes it more difficult to write complete contracts and makes outsourcing less desirable. (4) How hard is it to measure quality? Ease of monitoring quality will tend to favor outsourcing. (5) How important is it to provide incentives to the lab manager to cut costs? If this is important, outsourcing will be more desirable. 19 14. Koji Incorporated produces high-end cameras. Its typical camera comes with an array of options. The company has a good brand name. a. Koji distributes its cameras through independent dealers who are given exclusive distribution rights for their respective market areas. Discuss why it might make economic sense for Koji to grant its distributors exclusive territories. Granting an exclusive territory is one of the most common methods for reducing free riding among distributors in a given market area. If there are multiple independent distributors in a market area, there can be strong incentives to free ride on the efforts of others in activities that promote the brand name, such as local advertising, providing high quality service, etc. Exclusive territories help the distributor internalize more of the benefits of his efforts. b. Since Koji adopted this distribution system, it has experienced a double markup problem. What is a double markup problem? Since both Koji and the independent distributors face downward sloping demand curves they have incentives to mark up the product above marginal cost. This double markup can increase price and reduce quantity relative to the price and quantity that maximizes the joint profits of the company. c. Discuss how Koji might use a two-part pricing scheme to reduce the double markup problem. (Be sure to specify what the two-part pricing scheme would entail.) Koji would sell the cameras to the distributors at marginal cost. Thus there would only be a single mark-up resulting in profit maximization for the system. Koji would take its profits through an up-front fee. The up-front fee could be no larger than the total system profits (since the distributors would not agree to a contract where they operate at a loss). The fee will be smaller if system profits are split among the company and distributors. 19-12
d. Describe one other method that Koji might use to address the double markup problem. Potential methods include mandatory quotas and resale price maintenance agreements (which may not be allowed by anti-trust law). The quota would be set at the joint profit maximizing output level. Koji could take its profits by a markup over cost. A resale price maintenance agreement would not allow the distributors to mark up price above the joint profit maximization level. 19-13