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Lecture 4

BUS 207 Lecture Notes - Lecture 4: Market Failure, Bilateral Monopoly, Vertical Integration


Department
Business Administration
Course Code
BUS 207
Professor
Karen Ruckman
Lecture
4

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Transaction costs analysis = more strategy based
o Consider: when to outsource/when to do things internally
Make = internal; e.g. intermediate Q, owning own raw mat, doing own shipping
service acquiring a supplier
Buy = external rely on an independent supplier
Make or buy continuum:
o Market transactions some/all external activities
o L/T contracts activities done by external firms but not done on spot market;
relationship
Spot market = hire any supplier, the cheapest one
o Strategic alliances & JV still different firms but more integrated b/c have relationship
& accountability
Alliance = can range from anything from handshakes to JV
JV = 2 firms that join to make separate 3rd firm
o Parent/subsidiary relationships some subsidiaries are very autonomous (act
separately) & sell their products to other firms in same subsidiary umbrella (corp)
o Perform activity internally do eerthig iterall; totall ertiall itegrated
Takes advantage of econ of scale
Generally, G flow from upstream to downstream
o Upstream = raw mat, downstream = retainers who sell final G
Different activities in VC = add value to entire process
o Note that the arrows in between each activity = another activity which counts (shipping)
Support/secondary activities = equally as important as primary activities
o Can be source for comparative advantage among firms
o Includes accounting, finance, HR, legal, marketing
o in main VC b/c affect every activity individually
When firms very developed back in the day, had to perform all activities internally
o Now due to developed economy, can specialize
o Internet also our economy so can do any activity from father distances
Very few companies do all activities themselves nowadays
Make or buy fallacies:
o Firms should buy, rather than make, to avoid costs of making product
o Forms should make, rather than buy,
If that asset = source of competitive advantage
To avoid paying П margins to supplier
b/c a vertically integrated producer will avoid high input prices during periods of
high D
Explanations:
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o E.g. Staples aufaturer ut a retailer, so the a’t ee ake the produt
aoidig the ost of aufaturig sie the do’t aufature
o Each reason
Golden rule of outsourcing = if can find a firm that can perform a particular
activity cheaper than you doing it internally, hire them!
Assuming same quality
Being greedy; if an external supplier can produce for you at a lower cost, should
hire
matter if they make a П, what matters is the cost you incur (which is
lower if you were with than rather than you producing internally)
Idea that if you own your own raw material, can avoid high input costs
To an extent this is true
However, there are ways to use market & avoid high input P by hedging
o Making a deal (accepting an offer) w/a raw mat provider to buy
certain amount of raw mat @ certain P on certain day in the
future
o If offered P > arket P, ill go to arket ad ot eerise the
hedge
o Supplier offers this b/c guaranteed sale in future
Benefits of using the market
o Can do to supplier for intermediate Q, & this specialization = takes advantage of econ of
scale
b/c supplier produces so much, econ of scale = exhausted lower cost
So, if Q = low, go w/external supplier
But if Q = high, go w/internal b/c costs = same but will have to pay small П
argi o eteral supplier that ou ould’t hae to pa to ourself
o Can avoid big costs (that large corps are subjected to, such as):
Agency costs
When workers & managers knowingly act in best interest of the firm
e.g. using express main instead of regular mail
Go unnoticed b/c big corps have complicated structures (many
dpts/etc.) so costs (esp. ones that are shared between these units) =
hard to identify
Influence costs
Cost of activities aimed @ influencing distribution of benefits within a
firm
E.g. cost of listening to lobbying of managers who demand more $ for
their dpt
Also includes misallocation of funds
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o E.g. supplier has to raise costs for Project 1 of a dpt b/c able to
drop costs of supplies for Project 2 (which they were expecting
to be able to do)
Costs of using the market (outsourcing)
o Coordination costs
When products have components that must relate to e/o in a precise way
Slight delays in a delivery may result in large delays in production
Think of a factory line
Even harder when some parts of production = perishable
o Information leakage
When external supplier also supplies competitors or is capable of forward
integration
Only really for high tech firms
e.g. biotech firm is working on product if passes tries, will be $$$ rev
o Transaction costs
Whe it’s ostl to researh, rite, efore otrats
Transaction costs = involve explicitly/implicitly contracts; are made up of:
o Information costs pre-contact search costs of finding a supplier, identifying them,
procuring them
o Contracting costs writing the contract (are attorney fees)
o Enforcement costs post-contract monitoring & settlement; can be the most $$$
When transaction costs are high, either the following can happen:
o Mutually beneficial exchanges take plae arket failure
o Market exchange may be abandoned and replaced by alternative means of allocating
resoures hierarhies
Do it internally instead
Transactions cost economics (TE) = studies alternative institutions of governance
o Governance = who controls owns the firm
o Meanwhile, unilateral governance = vertical integration and bilateral governance = JV
Main purpose = to determine the size & scope of firms; particularly the optimal degree of
vertical integration & contracting out
Basic behavioral concepts of transaction cost analysis:
o Bounded rationality
Limited ability of people to think of all possible scenarios after writing contracts
Outcome = most contracts = incomplete
May have to satisfice & operate w/some uncertainty
o Opportunism
Self-interested behavior that takes adv of incomplete contracts to maximize
personal adv by withholding/distorting/misrepresenting info
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