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Chapter 3

Chapter 3 textbook (4th edition)

Economics for Management Studies
Course Code
Jack Parkinson

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ECMC40 Chapter 3
-Vertical chain: the process that begins with the acquisition of raw materials and ends
with the distribution and sale of finished G & S
-Vertical boundaries: of a firm define the activities that the firm itself performs as
opposed to purchases from independent firms in the market. ( ie vs outsourcing)
-Make or buy decision: a firms decision to perform an activity itself or to purchase it
from an independent firm. Make means that the firm performs the activity itself; buy
means it relies on an independent firm to perform the activity perhaps under a contract
-Goods in an economy flow: along a vertical chain from raw materials and component
parts to manufacturing through distribution & retailing.
Early steps in the vertical chain are upstream in the production process
Later steps are downstream
-Large hierarchial enterprises in the 1900s performed these support services
(figure 3.2) themselves to coordinate the flow of production through the vertical chain.
Sometimes, these support activities became principal sources of value creation in
integrated firms.
-Market firms: specialists in the market. They include many recognized leaders in their
By using these firms, a manufacturer can obtain a superior marketing program, low cost
distribution, and accurate reports about payroll, sales & inventories without having to
perform any of the tasks itself.
However, its not always desirable to use the market, a critical task for any firm is to
define its boundaries by determining what tasks to make and what other to buy.
-Defining boundaries: regardless of a firms position along a vertical chain it needs to
define its boundaries. To resolve the make or buy decision the firm must compare the
benefits and costs of using the market as opposed to performing the activity in house.
 Benefits & costs of using the market
1) Market firms (MF) can achieve EOS
that in-house departments producing
only for their own needs cannot.
1) Coordination of production flows
through the VC may be compromised
when an activity is purchased from
an independent market firm rather
than performed in house.
2) MFs are subject to the discipline of
the market and must be efficient &
innovative to survive.
Overall corporate success may hide
2) Private information may be leaked
when an activity is performed by an
independent market firm.

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the inefficiencies and lack of
innovativeness of in house departments. 3) There may be costs of transacting
with independent market firms that
can e avoided by performing the
activity in house.
-Make or buy fallacies: 5 common INCORRECT arguments
1) firms should make an asset rather than buy it of that asset is a source of competitive
advantage for that firm
Correction: if it is cheaper to obtain an asset from the market than produce it internally,
the firm should do the former.
2) Firms should buy rather than make to avoid the costs of making the product
choosing to buy rather than make doesnt eliminate the expenses of the associated
activity. Make or buy decisions can however, affect the efficiency with which the activity is
carried out.
3) Firms should make rather than buy to avoid paying a profit margin to independent
firms (our firm should backward integrate to capture the profit of our suppliers for
ourselves )
there are 2 flaws in the statement: A) there is a difference between accounting &
economic profit. Accounting profit is the simple difference between revenues and
expenses. Economic profit represents the difference between the accounting profits from
a given activity and the accounting profits from investing the same resources in the most
lucrative alternative activity.
In general AF exceeds EF . Because EF speaks to the relative profitability of different
investment decisions it is more useful than AF when making business decisions.
Even if an upstream supplier is making AFs this doesnt imply that it is making
economic profits or that a downstream manufacturing firm could increase its own EFs by
internalizing the activity.
4 ) Firms should make rather than buy because a vertically integrated producer will be
able to avoid paying high market prices for the input during periods of peak demand or
supply ( By vertically integrating we obtain the input at a cost thereby insuring ourselves
against the risk of high input prices.
5) Firms should make to tie up a distribution channel. They will gain market share at the
expense of rivals. This is used to justify acquisitions on many other occasions when it lacks
-Reasons to BUY
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