Vertical Boundaries

Chapter 10: Vertical boundaries Chapter 10: Vertical boundaries Aim of the chapter To understand the factors that influence the ways in which transactions on a vertical chain (value chain) should be/are located on the market–organisation continuum. Learning objectives On completion of this chapter and the essential reading, you should have a good understanding of the following terms and concepts: • transaction cost economics • strategic calculation. Essential reading Buchanan, D. and A. Huczynski Organizational behaviour: an introductory text. (London: Prentice Hall, 2008) Chapter 18. Douma, S. nd H. Schreuder Economic approaches to organisations. (London: Prentice Hall, 2008). Further reading Besanko, D. , D. Dranove and M. Shanley Economics of strategy. (New York: Wiley, 1996). Coase, R. H. ‘The problem of social cost’, Journal of Law and Economics 3 1960, pp. 1–44. Grossman, S. and O. Hart ‘The costs and benefits of ownership: a theory of vertical and lateral integration’, Journal of Political Economy 94(4) 1986, pp. 691–719. Williamson, O. E. ‘The economics of organization: the transaction cost approach’, American Journal of Sociology 87(3) 1981, pp. 548–77. 10. 1 Introduction
As noted in Chapter 1, we may regard the basic unit in organisational analysis as an exchange or transaction generated in the division of labour. The division of labour (exogenous/endogenous – Chapter 3) creates value or vertical chains; for example as shown in Figure 10. 1(a) running from crude oil extraction to the retailing of petroleum products. We now operate at the level of organisations or firms (recognising that at a greater level of disaggregation the points in the chain are also based on chains of the division of labour) and pose the question as to where their boundaries should be located on the value chain.
In fact the picture is usually more complex than the one depicted in Figure 10. 1(a). Activities usually depend on inputs at all points down the vertical chain, as depicted in Figure 10. 1(b). So organisations or market exchanges could control and coordinate each of these transactions. Furthermore, some of these inputs may be common to the points on the main chain (see Appendix 1. 2 in this guide), like accounting services, in which case the picture looks more like Figure 10. 1(c). Note the use of di-graphs once again. 91 Organisation theory: an interdisciplinary approach a) Oil extraction Refining Retailing • (b) Shipping or pipe • • • Distribution • • • • (c) • • • Accounting • Figure 10. 1 • • • In general we are asking the question as to whether a particular transaction should be internalised (make) or left in the market (buy), as depicted in Figure 10. 2; that is, whether a point on the chain should be a department/ function or division or remain independent. For the moment we restrict our attention to this simple choice rather than the more elaborate positioning on the market–organisation continuum.

We shall return to the more elaborate issue later on. • • Market (Price mechanism) Figure 10. 2 Start by asking what the benefits and costs of using the market might be. The benefits could include the following: • Independent firms may be able to reap the benefits of economies of scale (i. e. operate at an output that minimises unit costs) whereas internal departments may not. Unless the firm itself can absorb all the efficient output of the department, it must either operate below the optimal output level or sell on to another firm.
This might compromise any information advantages of the purchasing firm (see below). • Independent firms are more subject to market disciplines than departments and may hold down costs they can control more effectively. Costs may be difficult to identify in departments. Firms might, though, attempt to replicate market incentives inside organisations. Tapered integration refers to a situation where a firm is supplied partially by an independent firm and partially by its own department. This allows their relative cost structures to be compared. Independent firms (i. e. their managers) may have stronger incentives to innovate when compared with managers of departments. • • Organisation • 92 Chapter 10: Vertical boundaries The costs of using the market might include the following: • Private information may be leaked to independent firms – particularly if there is a need to share technical information. • The focal firm becomes to a degree dependent upon an independent supplier (depending upon switching costs).
Thus the latter has a power resource (see Chapter 6) and may use it to hold up the focal firm. It may prove difficult to control and co-ordinate flows of goods and services down a vertical chain of independent firms. This may be particularly so where there is a need to fit the products closely. ‘Just-intime’ methods seek to overcome this problem and permit independent firms often with long-term relational contracts (see below). The way most economists (following Coase and Williamson) think about the choice between a market and organisational exchange/transaction is entirely predictable – choose the arrangement that minimises costs. The innovation here is to ntroduce the idea of transaction costs – the costs involved in making (controlling and co-ordinating) the transaction. They are sometimes referred to as agency costs, and agency efficiency is found where they are minimised.
So, if both production costs (which relate to technical efficiency) and transaction costs vary between organisational transactions and market transactions, then the total costs should be minimised. Activity Now read Sections 8. 1 and 8. 2 in D and S. If you would like to read a slightly more comprehensive economic approach to vertical integration, then read Besanko et al. 1996). In a world of fully informed, rational actors where contracting is complete, there are no transaction costs and the choice between market and organisational exchange is of no consequence (at least as conceived within this framework) unless production costs vary (which, again, they should not under the same assumptions). It is because we relax both the assumptions of full rationality and full information in the context of ‘real markets’ that transaction costs arise and the choice between market and organisational transaction is pertinent.
Transaction costs theory is used both in a normative and positive sense. The new assumptions are as follows: • Individual bounded rationality: people are intentionally rational but limitedly so. Individuals are neither able to make very complex calculations nor to assimilate large amounts of information. As you might expect, sociologists tend to like this assumption; they see it as more realistic than the full assumptions of rationality. • Opportunism: individuals are not only self-interested but behave with guile.
For example, in the context of game theory, individuals will issue promises which are not credible, make use of asymmetric information and they cannot be trusted. • Contracting about transactions is incomplete because of inherent uncertainty and incomplete information. • Contracting can thus lead to ex ante opportunism (namely, adverse selection) and ex post opportunism (namely, moral hazard). • These hazards will be exacerbated to the degree that there is little choice of transacting partners and therefore reputations (see Chapter 7) in respect of third parties will not constrain opportunism – small numbers exchange. 3 Organisation theory: an interdisciplinary approach • Anticipated repeated interaction will make reputations important to both parties but if in the process there is learning by doing, it is then costly to later switch exchange partner. Williamson (1981) calls this the ‘fundamental transformation’ – it ties the parties into the relationship. • Williamson also observes that parties to a transaction might have a preference for a certain type of transaction in addition to the costs and benefits. He calls this ‘atmosphere’. In effect Williamson is introducing wider motives/utilities.
Although the vocabulary introduced by Williamson is rather daunting at first sight, it has the advantage that it should link your thoughts into many of the ideas you have already encountered. Activity Think of transactions as a prisoner’s dilemma or trust game. Both parties would like to contract to achieve Pareto efficiency but each is wary of the other and in the absence of some mechanism to offset this wariness, the exchange does not materialise – the Nash equilibrium. So what mechanisms are available? You should be able to list the mechanisms.
They can be derived as follows. Competitive market – the price as a sufficient statistic; here the prisoner’s dilemma does not model the situation. Organisation – three possible mechanisms which can produce the Pareto-efficient outcome rather than the Nash equilibrium are: 1. Authority and power. 2. Trust (cultural mechanisms). 3. Repeated transaction and reputation effects. As we have seen in earlier chapters, alongside monitoring and employment contracts (incentives), we expect organisations to avail themselves of a mixture of these mechanisms.
But note, if we think in terms of ‘real markets’ rather than the ideal type of perfect markets, then the price mechanism is not sufficient and perhaps these mechanisms might also apply at different positions on the market–organisation continuum. We shall return to these matters later. Transaction cost economics embraces not only an unorthodox model of the individual but characterises aspects (‘dimensions’, to use D and S’s terminology) of transactions that impact upon the transaction costs.
Activity Now read Section 8. 3 in D and S. The argument is that asset specificity (sometimes called ‘relation-specific assets’), uncertainty/complexity and frequency of exchange all increase the likelihood that a transaction will be placed (governed) inside an organisation (that is, make) rather than left to the market (that is, buy). Asset specificity comes in different forms: • site specificity – adjacent sites, usually to economise on transport and communication costs • physical asset specificity – e. g. pipeline delivering crude oil • dedicated assets – assets of a particular buyer dedicated to a particular relationship • human asset specificity – skills dedicated to a particular relationship which would be less valuable elsewhere. 94 Chapter 10: Vertical boundaries So we now have a predictive theory about vertical integration and, incidentally, contracting out. By and large, empirical evidence has supported transaction cost theory – particularly the impact of complexity in the context of uncertainty – though one should bear in mind what Williamson terms ‘atmosphere’.
If there are widespread specific preferences – for instance, managers might prefer the power implied by organisation – this would complicate the picture. Furthermore, other factors might influence the choice between market and organisation. Regulation and taxation can confer advantages in deciding where profits are generated. For instance, taxation might favour small firms, and firms operating across different national tax regimes may find it an advantage to contract out. An organisation might vertically integrate to gain a monopoly or acquire information or to limit the flow of information to competitors (see below).
Given all these possibilities, it is perhaps surprising that such strong empirical support for transaction cost theory is found. Appendix 10. 1 in this guide gives a slightly more formal approach to Williamson’s reasoning. The transaction costs approach still leaves open two questions: 1. Will the integration, if appropriate, be backwards or forwards? 2. What type of organisation – e. g. centralised or decentralised hierarchy? (I leave an answer to this question to Chapter 12. ) An extension of transaction costs theory called property rights theory (which is not covered in D and S) provides an answer to the first question.
When a transaction is internalised within an organisation, then ownership should (note the normative word) go to the party with the greatest impact upon the post-contractual rents. Activity Although this theory falls beyond this course, you might like to read Grossman and Hart (1986). Property rights theory is essentially a theory of bargaining power. Incomplete contracts mean that residual extra-contractual control of assets is important. Ownership confers bargaining power over operational decisions when enforceable contracts break down.
Anticipation of post-contractual hazards determines earlier investment decisions. We now need to complicate the picture by reintroducing the market–organisation continuum, as in Figure 10. 3. I use the term ‘continuum’ with a certain amount of licence as the alternative positions on it vary in a number of respects and could be reordered. The continuum runs from perfect competition, at one end, to integration or organisation, at the other. The question now is: where should a transaction be placed on the continuum?
Before answering this, let us look at what B and H have to say about the issues we have been discussing. 95 Organisation theory: an interdisciplinary approach Spot markets (perfect competition) Real markets Bargaining Franchising Long term contracts (network organisations) Tapered organisations Virtual organisations Alliances Joint venture Monopoly (small numbers) Externalities Asymmetric information Fixed cost (risk to supplier) Risk sharing Cost plus (risk to buyer) Decentralised Integration (up/down) organisation Figure 10. Activity Now read Chapter 18 in B and H. Again, this chapter in B and H is extremely detailed; you need to master the main ideas running down the left-hand margin. None of them is inconsistent with anything you have learned from D and S; though note that the definition of vertical integration is in fact backwards vertical integration. Table 16. 3 in B and H gives a good overview of what I have termed the organisation–market continuum. So let us now return to the continuum – see Figure 10. 3 – keeping the rich descriptions in B and H’s chapter in mind.
First, look at what I have termed ‘real markets’. Here we recognise that in the real world the market environment is often far from perfectly competitive. If the transaction is left to the price mechanism, then various market distortions may undermine the price as a sufficient statistic. If, for instance, a supplier holds a monopoly, then backwards vertical integration may look attractive to a buyer. Likewise, a buyer might be tempted to vertically integrate backwards in order to acquire information or to reap benefits of vertical synergies (externalities).
Long-term contracts (which will inevitably be incomplete) enable organisations to engage in a protracted relationship. They often occur between buyers and suppliers in a vertical chain. D and S introduced the idea of ‘relational contracting’ (an equivalent term). Remember, whenever you think in terms of contracts you need to think of the incentive, risksharing and information aspects. Fixed-term contracts put the risk of, say, increases in input prices to the supplier on the supplier’s back. Cost plus contracts reverse the situation. Between these two extremes, risk-sharing contracts can be designed.
If the buyer and supplier have differing risk preferences then, other things being equal, an optimal contract can be found. Network and virtual organisations (see B and H) are usually based upon long-term relational contracts, as are alliances. Joint ventures imply equity contribution from both the supplier and buyer. Centralised 96 Chapter 10: Vertical boundaries So the question now is: where should a particular exogenously generated (by the division of labour) transaction be placed on the market–organisation continuum? (The normative question. Alternatively, where is it placed and why? (The positive questions. ) Transaction cost economics claims to be both normative and positive and answers both questions – minimise transaction and production costs! But as we have seen, this is only part of the story. Activity Now read Section 9. 8 in D and S. In summary, the choice of the position of any vertical transaction on the market–organisation continuum may be shaped by: • economies of scale • anticipated information leakage • acquiring information • transaction costs • residual property rights • market imperfections • regulation.
But how are these various strands to be woven together? Unfortunately there is, as far as I am aware, no embracing theory. B and H introduce you to the concept of corporate strategy and to what many organisation theorists term strategic choice. Although the idea that organisational arrangements designed to control and co-ordinate activities are a matter of choice was first introduced by sociologists in reaction to an earlier tradition that spoke of ‘determinism’ – often technological determinism – we can now see this as an unhelpful distinction.
Economists will always speak of choice where changing technology might either enhance or restrict the opportunity set which rational decision-takers face. We might then like to think of technological determinism when for whatever reason, the opportunity comprises a single option. I encourage you to think in these terms even if you want to question the restrictive notion of rationality (see Chapter 1). Activity Now read Chapter 9, particularly Sections 9. 1–9. 7, in D and S. Sections 9. 1 to 9. 6 of D and S cover issues of strategic planning that impinge upon organisation theory but are more often encountered in courses on management theory.
You will benefit from reading them but they are not central to this unit. The central idea in management theory concerns the sources of what is termed sustained competitive advantage (SCA). Why do some firms/organisations manage to sustain a better performance than their competitors, while operating in the same markets? Statistics tend to suggest that this is a common experience in many markets. Firms often earn above-average returns (loosely rents) on their assets over relatively extended periods of time. The assumption is that they have some characteristics (but which? that their competitors find it difficult to replicate or improve upon, at least during the time in which the advantage is sustained. From an organisational theory point of view the question to ask is – are there ways of organising which can confer SCA? Notice that when an organisation possesses a competitive advantage, for whatever reason, then this implies that perfect competition is not operating. In so far as those running organisations seek SCA, they are trying to undermine 97 Organisation theory: an interdisciplinary approach competitive forces.
The early sections of D and S’s chapter show how game theory is an indispensable tool in studying competitive strategies. 10. 2 Vertical contracting and strategic choice Consider a transaction between B and S, as in Figure 10. 4. The problem is to design a contractual relationship to gain any possible rents. In terms of competitive advantage this amounts to placing the transaction on the market–organisation continuum more effectively than the competition. Assume that there is need for relation-specific assets and a complete contract cannot be signed because of inherent uncertainties.
Suppose now that B would like to persuade S to make the relation-specific investment. S’s ex ante problem is that in the absence of trust and credible promises, s/he anticipates that, once the investment is made, B will take advantage of the situation. S anticipates that B will always be able, once the contract is entered into, to find contingencies not covered by the contract. By making the investment, S in effect confers bargaining power upon B – who may even use this power to renegotiate the original contract (attempt to reduce the price of the good or service exchanged).
S will then anticipate these moral hazards and accordingly not invest; the transaction will fail and both S and B will be less well off than they could be. Thinking in terms of the (for the moment, one-shot) prisoner’s dilemma, S and B find a Nash equilibrium rather than the Pareto-efficient outcome. So what can be done to achieve the Pareto superior outcome? S Figure 10. 4 B Some possibilities (neither exclusive nor exhaustive) are: • B makes the relation-specific investment (but then B confers bargaining power to S) • B nd S make a joint investment – an alliance or joint venture • S continues to make the investment but enters into a long-term contract with B (note that relation-specific investments tend to imply long-term relationships in the first place) • forward or backward integration (here non-market incentives/ monitoring/authority/power/culture achieve the move from the Nash equilibrium to the Pareto outcome). But let us continue to assume that B wants to find a non-integration solution and still to encourage S to make the costly upfront relation-specific investment.
S/he might do this in the recognition that S, as an independent organisation, may be relatively small, flexible and focused. S, furthermore, may be driven by a more entrepreneurial spirit than if it were to be a division or department in B’s ‘bureaucracy’. An independent S may be more innovative. Also small organisations tend to have lower labour costs (production costs). If so, then both S and B can benefit. The strategic problem is whether or not the transaction costs (ex ante and ex post) can be kept down while reaping these potential advantages.
To offset S’s anticipated moral hazard problems, B needs to search for ways of reducing her/his own and increasing S’s relative bargaining power. To the degree that this proves possible, the strategy will offset S’s anticipated moral hazards. B needs to make her/himself more dependent upon S before the contract is signed. One notable way s/he can secure this is to decentralise some design and innovation responsibilities to S. B now becomes partially dependent 98 Chapter 10: Vertical boundaries upon S. Furthermore, B can commit not only to a long-term contract but also to relatively unconditional contract renewal.
These strategies do of course put B at some risk. But since we are thinking in terms of incentives to transact, you should by now recognise that risk-sharing is another aspect of the possible contracts between S and B that can be subjected to strategic reasoning. Not unreasonably, I think, assume that S is risk-averse and B is risk-neutral. So S will accept a reduction in rent in order to reduce his/her risk and, relatively speaking, B will be prepared to shoulder more risk. So, a risksharing, long-term contract can conceivably lead to a Pareto improvement. Think in terms of post-contractual price negotiation.
With a fixed-cost contract any increase in S’s costs will have to be borne by S. S will be reluctant to sign such a contract. With a cost-plus contract, on the other hand, B will bear all the risks of S’s cost increases. Furthermore, S will have no incentives to hold costs down nor, perhaps more importantly, to innovate in order to reduce costs. Clearly, B wants S both to innovate and, where possible, to hold down costs. It is not in B’s interests to take the risk from S and undermine these incentives. How can s/he provide appropriate incentives while reducing S’s risks and in so doing make the contract interesting to S?
What B needs to do is to accept those risks of cost increases which S cannot control while making S responsible for those s/he can control – a tricky business. B needs to know the nature of S’s cost structure (an information problem – no problem with full information but with information asymmetry it is another story) before s/he can achieve this. Of course, integration might dispel this problem but then we encounter the bureaucratic losses mentioned above. What can B do? Go back to your principal–agent model (see Chapter 4). We can regard B as a principal and S as an agent.
P (B) can acquire information by having more than one agent (S) operating in the same environment (in practice this is not easy). This is called multiple sourcing. It could be achieved by either multiple external sourcing or having an in-house comparator (tapered sourcing). But, of course, one needs to ask whether B’s sourcing requirements are of sufficient magnitude to reap any economies of scale across the multiple sources. If not, would it be sensible – from an information leakage point of view – to allow the sourcing organisation to sell to other organisations on the open market?
If B has decentralised design to S then this might prove hazardous. As we have observed, long-term relationships (see Chapter 8) can invoke trust and reputation effects. Traditionally it was assumed that one of the advantages of integration into an organisation derives from the repeated interaction effects. B and S being in the same organisation, they repeatedly interact and, indeed, they will assume that there is a high enough probability that they will once again interact in the future. Thus prudent calculation can overcome the moral hazards in incomplete contracting.
In game-theoretic terms B and S may play TFT (the folk theorem). B may also wish to protect her/his reputation for fair play. In short, an organisation can control and co-ordinate vertical relations by cultural means. However, long-term contracts with a continuation clause also produce repeated interaction (the Japanese were largely responsible, in the 1980s, for recognising this) and, thus, reputation and trust can be generated at other points on the market–organisation continuum. Cultural mechanisms can operate outside formal organisations.
If B and S can trust each other not to behave opportunistically, then the advantages of S’s independence and reduced transaction costs can be realised. 99 Organisation theory: an interdisciplinary approach Finally, reverting to an extended value chain where S’s suppliers are also brought into the picture, we obtain the situation as in Figure 10. 5. • • R S B Price and market > • > • • R S B Long-term contracts > • > • • R S B Organisation p of co-ordination = 3 > • > • Figure 10. Should the whole chain be co-ordinated by integration (p of coordination) or perhaps co-ordinated by long-term contracts, etc.? If the latter, should B contract with S and R or should B contract with S and S with R? In either case we have examples of network organisation and even virtual organisation if the relationships are mediated by modern information technology. The strategic complexion of these sorts of organisation is little understood. Why don’t you have a go! I hope this section has given you some appreciation of how to analyse organisation choices from a genuinely strategic point of view.
Much of the above reasoning can be underpinned from a game-theoretic standpoint. This further supports my earlier contention that modern organisation theory often requires a knowledge of strategic thinking and game theory. A reminder of your learning outcomes On completion of this chapter and the essential reading, you should have a good understanding of the following terms and concepts: transaction cost economics strategic calculation. Sample examination question 1. Explain why a transaction should be placed in a market or an organisation. 100

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