Vertical Relationships Chapter 14 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible.

1

Vertical RelationshipsChapter 14

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible

website, in whole or in part.

2

Introduction

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

or in part.

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3

The Ore Carrier

U.S. Steel Corporation’s Roger Blough (rhymes with “how”) is a type of boat seen only on the Great Lakes. She (ships are still gendered

female) is an iron ore carrier. Why does U. S. Steel own the Roger Blough (named after a former executive), the ore mine and the

processing facility?


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What’s Next?

In this chapter we explore why U.S. Steel and other firms are vertically integrated. We will examine how

businesses determine the activities they will perform in-house and those for which they will rely

on outsiders. A management’s decision on the vertical scope of its business is as important as its

decision on the good or service to produce.


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THE VERTICAL DIMENSION


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Goods (or Services) in ProcessThis figure shows how about 50 percent of America’s steel

is currently produced. It summarizes the vertical steps in steelmaking. An

earlier step is called upstream and a later one downstream. A firm that controls several steps is

vertically integrated. The alternative to integration is a

contract or market relationship in which a

downstream firm buys an upstream producer’s output.


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Transaction Costs and Vertical Integration

Volumetric Interdependence: The production and milling of hot steel have a high volumetric

interdependence. The blast furnace must produce just enough pig iron for steelmaking, and at just the right times. If coordination fails and the liquid solidifies,

reheating is costly.Adapting to Uncertainty: If different people own the

furnaces and mill they face risk-sharing problems like the pin producers of Adam Smith. A complete contract that handles all possible risks will be impossibly costly

to write and enforce.


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Opportunism, Thin Markets, and Vertical Integration

Integrated Ore Mines and Shipping: Transaction costs, uncertainty, and risks of opportunism can also explain why U.S. Steel owns its mines, enrichment

facilities, and ore carriers.

Unintegrated Coal Mines: But although U.S. Steel is integrated into iron mining, it currently does not own any of the mines that supply its coking coal. Coal is a

less specific resource than iron ore; it trades at competitive prices, and U.S. Steel can hedge any

remaining risks without having to own mines.


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Changes in Vertical IntegrationHow Steelmakers Became Integrated: Economies of scale drove

firm sizes upward, and the Bessemer converter’s operating characteristics motivated their integration into mining.

Why Steel Is De-integrating Today: Mini-mills fill an electric furnace with scrap steel, feed in high-voltage power, and in as

little as two hours the scrap will be melted and ready for casting. Like an integrated

producer’s, a mini-mill’s volumetric interdependence explains the integration of its casting and milling activities. There are, however, few reasons for a mini-mill to own a source of scrap

steel, which trades in a worldwide market with many competing sellers.Demand-Driven Changes: Looking at another industry, most

meats and vegetables were once produced by independent farmers, who sold them in spot markets to independent packers

or grocers. Economies of scale became pervasive over the twentieth century for some farm products.


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Summary: Principles of Integration and Separation

A firm chooses vertical integration if doing so reduces costs below those it would incur in markets.

This table shows how different degrees of asset specificity and uncertainty can affect the choice of

markets, contracts, or integration.


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VERTICAL MERGERS AND CONTRACT RESTRICTIONS


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Mergers and Agreements - Successive Monopolies

Jones is a nondiscriminating monopolist who produces good

A. Assume that his only cost is for input B, and it takes a unit of B to produce a unit of A. Unfortunately

Jones’s only source of B is Smith, who is also a single-price nondiscriminating monopolist. A and B

are produced by successive monopolies that face the problem of double marginalization. If they operate independently their joint profits are smaller than if

they cooperate. They can solve the problem by merging or devising a contract.


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Mergers and Agreements – Price Discrimination

The Aluminum Company of America (Alcoa) had a near monopoly in the United States during the first

half of the twentieth century. Alcoa sells aluminum to aircraft producers

whose demand is inelastic and to cookware manufacturers

whose demand is elastic. Alcoa would benefit from charging

Different prices to these customers, however, they could not prevent cookware producers from ordering

large volumes of aluminum and reselling some to aircraft manufacturers. The company solved its problem by vertically integrating into cookware

production.


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Mergers and Agreements - Avoiding Price Controls

Gas sells in a competitive market, and there are no controls on its price. The maximum rates pipelines

can charge, however, are set by the federal government. During peak periods, however, demand at the maximum price can exceed available capacity.

A buyer willing to pay more has the option to arrange a “buy-sell” transaction with the pipeline. In

a buy-sell the pipeline offers to resell gas it purchased in the market for a higher price than it

paid. By integrating into gas production or contracting with a producer the pipeline evades the

legal ceiling on its transportation charge.


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Mergers and Agreements – Obtaining Market Information

Assume that your firm uses large amounts of some input, which you buy from several different

producers without facing transaction costs or opportunism that might otherwise warrant vertical

integration. The prices you pay are individually negotiated, but you may be at a disadvantage

because you do not know the producers’ true costs and may be paying more than you have to. To gain

information, you might consider integrating into the production of this input, not just to obtain part of

your supply but also to better estimate the costs of other producers.


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Vertical Restraints - Complementary Skills and Competition

The steps in a vertical chain may require quite different resources and skills. Ford Motor Company designs, produces, and nationally advertises its cars, but an actual sale requires effort by a local dealer. In

cases like these an agreement that assigns responsibilities to different parties could

turn the organization into a stronger competitive entity than if all of the responsibilities. One common agreement is a franchise contract between a parent company (the franchisor) and the operator of a local

outlet (the franchisee), specifyingeach party’s duties and the structure of payments that

will link them.


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Vertical Restraints - Free Riding

Like all contracts, franchising is subject to risks of opportunism. These risks can be aggravated by the

fact that a brand name has some properties of a public good. A full enumeration of all possible

opportunistic behaviors may be impossible, but the success of the brand requires the parent company to be able to sanction franchisees who are not making

the expected effort.


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Vertical Restraints - The Structure of a Franchise Contract

A franchise contract must reward sales efforts by the franchisee while acknowledging that any relationship between effort and results is inexact. The contract must thus be structured to motivate the franchisee.Franchisor and franchisee are in a principal-agent relationship with the same types of monitoring problems and risks of opportunism we previously encountered. To lessen them, many franchise contracts have similar structures:

• the franchisee pays a fixed annual fee for the right to operate.

• the franchisee pays a royalty, usually a monthly payment that averaged 5.1 percent of gross revenue in 2001


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OUTSOURCING AND REFOCUSING


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The Decision to Outsource

The logic of vertical integration is also the logic of de-integration, nowadays often called “outsourcing.” It has

grown steadily over the last half of the twentieth century in all industrialized nations.


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Asset specificity and uncertainty are major factors in de-integration, but they act in opposite directions. A management’s choice to outsource also depends on

its ability to evaluate and compare external to internal performance.

When activities are common and standardized, and few investments on either side are specific to a

relationship with a particular provider, outsourcing is a good option.


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Change the task and outsourcing becomes more difficult. Assume that the design of your firm’s

products must constantly change if the firm is to maintain its edge over competitors. Design and

engineering require contact with customers, intelligence about competitors, and familiarity with the details of your own manufacturing process. You

areunlikely to outsource designing or manufacturing for

several reasons.


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Some Trends to ExplainIt is hard to estimate the overall importance of

vertical integration in an economy, but evidence points to a general decrease since the 1970s. Firms

encompass fewer stages ofproduction, and market transactions are replacing

activities that formerly took place inhouse.The largest single employer in the country is not

General Motors, but a temporary employment agency called Manpower Inc. The largest owner of passenger

jets is notUnited Airlines, or any other major carrier, but the

aircraft leasing arm of General Electric.


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Some Trends to ExplainFunctions formerly undertaken within a firm are

being replaced by transactions between firms, and they often cross national boundaries in the process.

In 1998, 30 percentof the dollar value of a typical American cars (that is,

brands first manufactured in the United States) originated in Korea, 17.5 percent in Japan, 4 percent in Taiwan andSingapore, 2.5 percent in the United Kingdom, and 1.5 percent in Ireland and Barbados.

Only 37 percent came from the United States.


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Some Trends to Explain

Statistics on international commerce point to the rise of de-integration. Trade in components of final goods (those sold to ultimate users) has

grown faster than trade in the goods themselves.


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Why the Change? - Markets and InformationMarkets increase the likelihood of finding trades that create more economic value. Air travel and telecommunications reduce the costs of meeting others and moving goods, as well as transaction costs like credit checking, translation, and visual inspections. The changes have helped toestablish markets where people need no longer actually meet.

Technological and social changes have lowered other costs of using markets.

The growth of international commerce is standardizing both containers and contracts. Commercial laws are being harmonized

and their terminology standardized for greater ease of making contracts and settling disputes.


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Why the Change? - Information, Scope, and Scale

This figure shows two long-run average cost curves.

The first, LRAC1, portrays a firm’s costs before the arrival

of inexpensive informationtechnology (IT), such as personal computers and

inexpensive telecommunications. As

industries adopt these less expensive, smaller-scale IT applications, the optimalsize of firms will shrink.


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Why the Change? - Internal and External Coordination

The full effect of the new technology on a firm’s size and scope will depend on what happens to the

benefits of internalrelative to external coordination. Some types of

technology and software may decrease the costs of internal coordination and make larger firms more

efficient.If IT increases the net benefits of external coordination by more than those of internal

coordination, its vertical scope will shrink and so will its size.

Vertical Relationships Chapter 14 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible.

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