WEEK 2 DISCUSION

1. Vertical integration
When does
outsourcing/ownership matter?

2. What is vertical integration?
 Vertical (or horizontal) integration means that
the assets that were previously held by two
firms are combined into a single firm.
 The result is either joint ownership or the sale
of one firm’s assets to the other.

3. Market Imperfections
 Upstream and downstream firm
 Downstream firm
 Monopolist with no costs
 Sets price to its market (mark-up over marginal
costs)
 Upstream firm
 Monopolist
 Sets input price to downstream firm anticipating
impact on demand

4. Vertical Integration
 Suppose upstream and downstream firms are
commonly owned
 Best internal transfer price is based on
upstream marginal cost, c.
 Market price set so that MR = c.
 Maximises joint profits

5. Impact on Profits
$
PS
PI
Downstream
Profit
c+t Downstream Marginal
Upstream Cost
Profit
c
Joint Marginal
Cost
Marginal Demand
Revenue
QS QI

6. Double Marginalisation
 With outsourcing
 Both firms charge a mark-up
 Higher prices, low overall profits, lower consumer
welfare (not very competitive if there is another
vertical chain)
 Solved by:
 Vertical integration
 Two-part tariffs
 More downstream or upstream competition

7. Can vertical integration
matter?
 The Coase Theorem tells us that asset ownership
does not matter for efficiency.
 Assumes complete contracting
 When contracts are incomplete there exist residual
rights of control (unspecified actions). According to
Grossman & Hart:
“To the extent that there are benefits of control, there will
always be potential costs associated with removing control
(i.e., ownership) from those who manage productive
activities.”

8. GM-Fisher Body
 1920s: General Motors purchased car bodies from
independent firm (Fisher Body)
 Technology change: wooden to metal
 GM built a new assembly plant that required reliable
supply
 wanted Fisher Body to build a new car body plant next to it
 no need for shipping docks etc.

9. Fisher Refused
 Fisher Body refused to make this investment.
 Feared that a plant so closely tailored to
GM’s needs would be vulnerable to GM’s
demands (hold-up)
 Eventually resolved this issue by vertical
integration -- could not find a contractual
solution

10. Merger Benefits & Costs
 Benefits to GM:
 Could make more demands of Fisher Body
 More investment or extra supply
 Costs to GM:
 Diminished managerial incentives
 If costs are lowered in the body plant, GM is better able to
appropriate these at expense of managers.
 Harder to keep those costs down.

11. Bottling Pepsi
 PepsiCo has two types of bottlers:
 Independent: owns assets of bottling operation
and exclusive rights to franchise territory. Can
determine how these are used - when to restock
stores etc.
 Company owned: decisions can be made higher
up; Pepsi can choose to delegate local marketing
to its subsiduary

12. Pepsi’s Control
 Pepsi cannot control how an independent bottler
operates in a territory
 If it wants a national marketing strategy (such as the Pepsi
Challenge), it can’t compel the bottler to cooperate
 By acquiring a bottler, Pepsi has ultimate control.
 If the subsidiary managers refused to participate in the
national campaign, they could be sacked and replaced.

13. Motivating Example Again
 Service requires a truck (the asset) for production
 Also, enhancing value are:
 a shipper, S (who wants to ship goods)
 there are also other shippers except that they have goods to ship that
are $100 less in value created
 a trucker, T (does this): can take care or no care in maintaining
truck;
 there are many truckers who can take no care but this particular
trucker is the only one that can take care
 Effort in care is relationship-specific and is now assumed to be
non-contractible
 Also assume that care is a skill that is developed (through habits
etc.). Therefore, it becomes embedded in the trucker’s human
capital.

14. Effort and Value
 Benefit from extended truck life
 No Care: truck’s value is $50
 Care: truck’s value is $200
 Trucker’s effort cost of care
 Minimal care: cost of $0
 High care: cost of $100
 Marginal Benefit = $150 > $100 = Marginal Cost
 Efficient to take care
What happens under different ownership structures for
the asset?

15. Non-contractible Investment
 Suppose bargaining took place after effort choice is
made
 There are four cases to evaluate.
 Minimal care and alternative shipper
 Minimal care and S
 High care and alternative shipper
 High care and S
 S is no longer essential and so their added value is
less than the T if they do not own the asset.

16. Will trucker take care?
Ex Post Added Values: How to Share $200
Ownership Shipper’s Trucker’s 3rd Party’s
Structure Added Value Added Value Added Value
(Expected (Expected (Expected
Surplus) Surplus Surplus)
Backward $200 $150 $0
Integration ($125) ($75) ($0)
Forward $100 $200 $0
Integration ($50) ($150) ($0)
Cooperative $200 $200 $0
($100) ($100) ($0)
Vertical $100 $150 $200
Separation ($16.66) ($66.66) ($116.66)

17. Incentives and Ownership
 Trucker can be easily replaced if does not take care.
However, under BI and 3rd party ownership (vertical
separation), does not expect to earn enough to
cover costs of $100.
 Will take care under FI: needs to have control rights
(i.e., right to exclude use of asset) in order to gain
sufficient surplus ex post.
 That is, under FI, by taking care, T gets $50 (=$150-$100)
but only $25 if it does not take care.
 Under Cooperative, taking care gives T $0 but not taking
care gives them $25.
 General principle: give control rights to agents
making important investments.

18. Efficient Integration Level
 As they encourage the trucker to take care,
forward integration is the only efficient
organisational form
 Do we expect asset ownership to track
efficiency?

19. Shipper Interests
 Shipper might choose to have a back haul. A
back haul adds value of $100 (independent of
level of care).
 Suppose that trucker – if they own the truck –
can find alternative customers for the back
haul. If expend cost of $10 will find alternative
customer adding value of $50.

20. Forward Integration
 Shipper’s added value ex post:
 $250 if trucker searches for alternative customer
 $300 if trucker does not search
 Trucker’s added value ex post
 $300 regardless of whether searches
 Searching improves trucker’s expected surplus
from $150 to $175; therefore, worth the $10
expense.
 If search very costly, BI may become efficient
again.

21. Optimal Firm Boundaries
 Ownership provides maximal incentives to
take non-contractible actions
 Optimal firm boundary depends upon:
 whose actions are hardest to encourage
 whose actions are most important for value
 Never vest ownership with someone who
does not provide a non-contractible action
(I.e., 3rd party)

22. What Happens in Trucking?
 Suppose that you could put on-board
computers on truckers to monitor drivers.
 Theory: easier to monitor driver’s care and
reflect it in explicit performance payments or
fines – therefore, less need for trucker
ownership.
 Baker & Hubbard (2000): use of OBCs has
increased non-trucker ownership especially
on routes that may be more subject to trucker
rent seeking.

23. Shipper vs. Carrier ownership
 What determines whether shippers use internal (captive) fleets or
for-hire carriers for a haul?
 Determines who owns control rights associated with dispatch
(truck scheduling)
 Shippers use internal fleets when want high service levels from
truck drivers
 Truck utilisation higher in for-hire fleets – ability to line up a
sequence of hauls for a truck – tight coordination (requires
dispatcher effort)
 Need for flexibility conflicts with search for back hauls
 Harder to motivate truck drivers when looking for high service
levels.
 Empirically: OBCs lead to more shipper ownership

24. Case: Insurance Industry
 Insurance industries
 In-house sales force: whole life
 Independent brokers: fire and casualty
 Choice determines ownership of client list

25. Effect of ownership
 Agent owns list
 cannot be solicited without permission
 agent looks for clients most likely to renew
 motivate agents by using renewal commission
 agent can hold-up company; threaten not to introduce new
products to clients
 Company owns list
 company can hold-up agent; threaten to increase
premiums that reduce renewal commission

26. Applying Grossman & Hart
 Choice between independent and in-house agents
should turn on relative importance of investments in
developing long-term clients by the agent and list-
building activities of the insurance firm
 Whole life: customer less likely to switch so searching for
long-term customers less important -- in-house
 Fire & casualty: searching for long-term customers is
important -- independent

27. Dynamic Issues
How does outsourcing and
integration performance change
over time?

28. T5 at Heathrow
 Project management handled internally
 Contractors on cost-plus contracts (not fixed
price as is usually the case)
 British Airports Authority wanted to keep
options open to change design specifications
throughout the life of the project
 Happy to engage in on-going managerial
attention

29. Fixed vs Cost Plus
 Fixed contracts
 Costs aren’t passed through
 High powered incentives to keep costs down
 Anticipate cost savings that might be achieved when tendering
 But contracts incomplete: so subject to renegotiation (also
anticipated in tender)
 Cost plus contracts
 Costs are passed through
 Low powered incentives
 No difficult renegotiations – easier to change designs during
project
 For complex projects that require lots of coordination, may be
better to use cost plus contracts

30. Car Manufacturing
 Varied patterns of outsourcing
 Some companies integrated (GM)
 Some outsource almost everything (Volvo)
 Novak-Stern case studies suggest that...
 External sourcing allows firms to access state-of-the-art
technology but leaves them open to hold-up and low effort supply
after the initial terms of the contract are satisfied
 Internal development is associated with inferior technology
development and high costs for an initial model-year, but there
are much greater opportunities for improvements over time

31. Performance Over time
Vertical Integration External Sourcing
 Deep vehicle- specific Global supply opportunities
Ex Ante knowledge base  Opportunity for well-
 Less knowledge of defined performance
Contracting
system-specific technology contracts
Opportunities  Difficult to enforce specific
performance criterion
 Continuing authority  Hard to enforce contracts
Ex Post relationship allows for after key requirements have
Renegotiation Outcomes redirection been met
 Potential for learning  Fewer continuing
relationships

32. Empirical Findings
Performance
(Consumer Reports)
Internal Sourcing
Outsourcing
Model Year

33. Summary
 No black and white choice in outsourcing
 Capabilities can improve over time
 Ability to coordinate internal or external teams
 Ability to improve internal performance
 Handling contractual disputes
 No ‘one size fits all’
 Complexity – design and parts

34. Principles of Efficient
Ownership
 Simple example
 Asset: luxury yacht
 Service: gourmet seafare
 Workers: chef and skipper
 Customer: tycoon
 Value created
 Tycoon value = $240 (no other customers)
 Substitutes for skipper’s skills (no added value)
 Chef: asset-specific action (no other yachts) for cost of $100;
necessary to provide service for Tycoon
 Time-line
 Date 0: chef chooses whether to take action
 Date 1: negotiate over division of $240

35. Ownership Outcomes
Owner Skipper Tycoon Chef
Division
240/3 each 0, 240/2, 240/2 0, 240/2, 240/2
(S, T, C)
Invest No Yes Yes

36. Skipper Value
 Now suppose, skipper has a non-contractible
(date 0) action
 for cost of $100 can increase value of service to
tycoon by another $240 (total now $480)
 for example, increases knowledge of local islands

37. Ownership Outcomes
Owner Skipper Tycoon Chef
Division
200, 200, 80 120, 240, 120 80, 200, 200
(S, T, C)
Invest No Yes Yes

38. Complementary Assets
 Now suppose there are other customers
who can use the yacht
 But tycoon can choose a non-contractible
action (e.g., plan entertainment schedule
for the year). Gives additional value of
$240.
 Yacht can be split in two: galley and hull

39. Divided Ownership
 Is it ever optimal for chef to own galley and
skipper to own hull?
 Division of value is: chef ($320), skipper ($320)
and tycoon ($240/3)
 Tycoon has to reach agreement with both while
skipper and chef only require their joint
agreement
 Better to give entire yacht to skipper or chef.
Tycoon’s incentive rises ($240/2)

40. Principles
 Never give ownership to dispensable
individuals
 Give ownership to indispensable agents
(even though may not make an investment)
 Vest ownership of complementary assets
with a single individual

41. Qualification
 Does asset ownership really improve incentives for
specific investments?
 Those investments create value
 But may reduce the asset’s value outside of the
relationship: it is specialised to the other agent
 Without ownership, do not care about this reduction
 Hence, it is possible that incentives could be reduced by
ownership

42. Summary
 Value of ownership
 Increased bargaining position (added value)
 Incentives to take non-contractible actions
 Ownership improves this by allowing agent to capture a
greater share of the rewards
 But diminishes the incentives of non-owners
 Who should own an asset?
 Agents taking non-contractible actions
 Important agents