Transactions Costs and the Scope of the Firm

2. Transactions Costs and the Scope of the Firm Which is more efficient : several specialist firms linked by markets, or the combination of these specialist firms under common ownership. VERTICAL PRODUCT GEOGRAPHICAL AREAS SINGLE V1 P1 P2 P3 A1 A2 A3 FIRM V2 V3 SEVERAL V1 P1 P2 P3 A1 A2 A3 SPECIALIZED V2 FIRMS V3 Common Issue--- What are TRANSACTION COSTS of markets compared with administrative costs of the firm?

3. Introduction (cont.) • Types of Diversification • Vertical integration • Strategy of acquiring control over additional links in value chain of producing and delivering products/services. • Backward integration • Moving closer to sources of raw materials by acquiring resource suppliers or manufacturing the components needed for production of final product. • Forward Integration • Just the opposite: moving closer to end-user (acquire retail outlets for distribution, etc.).

4. Exhibit: Vertical Integration Backward Integration Forward Integration

5. Determinants of Changesin Corporate Scope • 1800 - 1975: Expansion in size & scope of biggest industrial corporations. Administrative costs of firms fell due to • Advances in transportation, information and communication technologies • Advances in management - accounting systems, decision sciences, financial techniques, organizational innovations, scientific management 1975 - 1995: Contraction in size & scope of biggest industrial corporations. Increased market turbulence, more competition, accelerated technological change Need for speed, flexibility, responsiveness Large, complex corporations become relatively less efficient

6. The Costs and Benefits of Vertical Integration: BENEFITS • Technical economies from integrating processes e.g. iron and steel production -- but doesn’t necessarily require common ownership • Superior coordination • Avoids transactions costs of market contracts from: -- small numbers of firms -- transaction-specific investments -- opportunism and strategic misrepresentation -- taxes and regulations on market transactions

7. Introduction (cont.) • Advantages of vertical integration • Greater control over costs and supply of components. • Avoids the transaction costs associated with dealing with vendors or retailers. • Ability to protect proprietary technology. • Ability to maintain or cultivate a company’s reputation for outstanding quality or service.

8. The Costs and Benefits of Vertical Integration: COSTS • Differences in optimal scale of operation between different stages prevents balanced VI • Strategic differences between different vertical stages creates management difficulties • Inhibits development of and exploitation of core competencies • Limits flexibility -- in responding to demand cycles -- in responding to changes in technology, customer preferences, etc. (But VI may be conducive to system-wide flexibility) • Compounding of risk

9. Introduction (cont.) • Disadvantages of vertical integration • Higher fixed overhead costs. • Integrated firms must deal with transfer price dilemma which can create serious morale and other internal problems. • Demand uncertainty creates problems. • Low demand can lead to underutilization of plant capacity. • High demand can result in dependence on outside suppliers. • Technological change can leave these firms stuck with old technology.

10. When is Vertical Integration More Attractive than Outsourcing? How many firms are available The fewer the companies to undertake the activities? the more attractive is VI Is transaction-specific investment If yes, VI more attractive needed? Does limited information permit VI can limit opportunism cheating? Are taxes or regulation imposed VI can avoid them on transactions? Do the two stages have similar Greater the similarity, the optimal scale of operation? more attractive is VI Are the two stages strategically Greater the strategic similar? similarity ---the more attractive is VI How uncertain is market demand? Greater the unpredictability ----the more costly is VI Does VI increase risk? If heavy investment required and risks between stages are inter- related----VI increases risk.

11. Designing Vertical Relationships: Long-Term Contracts and Quasi-Vertical Integration • Intermediate between spot transactions and vertical integration are several types of vertical relationships ---such relationships may combine benefits of both market transactions and internalization • Key issues in designing vertical relationships -- How is risk allocated between the parties? -- Are the incentives appropriate?

12. Recent Trends in Vertical Relationships • From competitive contracting to supplier partnerships, e.g. in autos • From vertical integration to outsourcing (not just components, also IT, distribution, and administrative services). • Diffusion of franchising • Technology partnerships (e.g. IBM- Apple; Canon- HP) • Inter-firm networks General conclusion:- boundaries between firms and markets becoming increasingly blurred.

13. Different Types of Vertical Relationship Low Degree of Commitment High Low Informal supplier/ customer relationships Vertical integration Supplier/ customer partnerships Spot sales/ purchases Formalization Joint ventures Agency agreements Franchises Long-term contracts High

14. The Internationalization of Industries The Process of Internationalization HIGH International Global Industries Industries --aerospace --automobiles --military hardware --oil --diamond mining --semiconductors --agriculture --consumer electronics Domestic Multinational/ Industries Multidomestic --railroads Industries --laundries/dry cleaning --retail banking --hairdressing --hotels --milk --consulting International Trade LO W LOW HIGH Foreign Direct Investment

15. Implications of Internationalizationfor Industry Analysis INDUSTRY STRUCTURE • Lower entry barriers around national markets • Increased industry rivalry --- lower seller concentration --- greater diversity of competitors • Increased buyer power: wider choice for dealers & consumers • COMPETITION • Increased intensity of competition • PROFITABILITY • Other things remaining equal, internationalization tends to reduce an industry’s margins & rate of return on capital

16. Analyzing Competitive Advantage within an International Context: The Basic Framework FIRM RESOURCES & CAPABILITIES -- Financial resources -- Physical resources -- Technology -- Reputation -- Functional capabilities -- General management capabilities THE INDUSTRY ENVIRONMENT Key Success Factors COMPETITIVE ADVANTAGE THE NATIONAL ENVIRONMENT -- National resources and capabilities (raw materials; national culture; human resources; transportation, communication & legal infrastructure -- Domestic market conditions -- Government policies -- Exchange rates -- Related and supporting industries

17. National Influences on Competitiveness: The Theory of Comparative Advantage A country is relatively efficient in the production of those products which make intensive use of resources which are relatively abundant within the country. E.g. • Philippines relatively more efficient in the production of footwear, apparel, and assembled electronic products than in the production of chemicals and automobiles. • U.S. is relatively more efficient in the production of semiconductors and pharmaceuticals than shoes or shirts. When exchange rates are well-behaved, comparative advantage emerges as competitive advantage.

18. Porter’s Competitive Advantage of Nations Extends and modifies traditional theory of comparative advantage to take account of the following factors: • Competitive advantage is about companies --- the importance of the national environment is providing a home base for the company. • Sustained competitive advantage depends upon dynamic factors-- innovation and the upgrading of firm’s resources and capabilities • The critical role of the national environment is its influence upon the dynamics of innovation and upgrading.

19. Porter’s National Diamond Framework 1. FACTOR CONDITIONS. “Home grown” resources and capabilities more important than natural endowments. 2. RELATED AND SUPPORTING INDUSTRIES. Competitive advantage occurs in “industry clusters” (e.g. semiconductors-computers-software in the U.S.). 3. DEMAND CONDITIONS. Discerning domestic customers drive quality and innovation (e.g. Japanese camera industry) 4. STRATEGY, STRUCTURE, RIVALRY. E.g. domestic rivalry drives innovation and upgrading. FACTOR CONDITIONS RELATING AND SUPPORTING INDUSTRIES DEMAND CONDITIONS STRATEGY, STRUCTURE, AND RIVALRY

20. Consistency Between Strategy and National Conditions In globally-competitive industries, firm strategy needs to take account of national conditions: • U.S. textile manufacturers must compete on the basis of advanced process technologies and focus on high quality, less price-sensitive market segments • Malaysian semiconductor manufacturers can be competitive in high volume, less technologically advanced items (e.g. memory chips) • Dispersion of value chain to exploit different national environments (e.g. Nike: R&D in U.S., components in Korea and Taiwan, assembly in China, Thailand and India, marketing in Europe and North America)

21. International Location of Production 3 considerations: • National resource conditions: What are the major resources which the product requires? Where are these available at low cost? • Firm-specific advantages: to what extent is the company’s competitive advantage based upon firm-specific resources and capabilities, and are these transferable? • Tradability issues: Can the product be transported at economic cost? If not, or if trade restrictions exist, then production must be close to the market.

22. International Location of Industrial Activities within the Value Chain Where is the optimal location of X in terms of the cost and availability of inputs? The optimal location of activity X considered independently What government incentives/ penalties affect the location decision? What internal resources and capabilities does the firm possess in particular locations? WHERE TO LOCATE ACTIVITY X? What is the firm’s business strategy (e.g. cost vs. differentiation advantage)? The importance of links between activity X and other activities of the firm How great are the benefits of linkages through proximity?

23. Overseas Market Entry: Alternative Modes TRANSACTIONS DIRECT INVESTMENT Exporting: Exporting: Exporting: Licensing Franchising Joint Wholly owned Spot Long-term with foreign technology venture subsidiary trans- contract distributor/ and Marketing & Fully Marketing Fully actions agent trademarks distribution integral- & sales integral- only ted only ted Key issues: • Is the firm’s competitive advantages based upon firm-specific or country-specific resources and capabilities? • Is the product tradable and what are the barriers to/ costs of trade? • Does the firm possess the full range of resources and capabilities needed to serve the overseas market?

24. Introduction (cont.) • Global diversification • Usually motivated by desire to grow (Boeing, Kellogg’s, Caterpillar). • Simplest route is exporting. • Others include licensing or franchising. • Most complex route is to establish wholly-owned subsidiaries.

25. Introduction (cont.) • Challenges in global diversification: • Most difficult challenge is to appreciate the unique cultures and customs of foreign markets. • Need for products to be adapted to accommodate these markets.

26. Alliances and Joint Ventures: Management Issues • Benefits: ability to combine different resources and capabilities of separate partners, ability to learn from one another. • Problems: management differences between the two partners. Conflict potential greatest where the partners are also competitors. • Collaborating with competitors: benefits seldom shared equally. Determinants of distribution of benefits: • Strategic intent of the partners- which partner has the clearer vision of the purpose of the alliance? • Appropriability of the contribution-- which partner’s resources and capabilities can more easily be captured by the other? • Absorptive capacity of the company-- which partner is the more receptive learner?

27. Multinational Strategies: Globalization versus National differentiation The case for a global strategy: • National preferences in decline-- possible to view the world becoming a single, if segmented, market. • Access to global scale economies--cost savings in purchasing, manufacturing, product development and marketing. • Strategic strength from global positioning-- but locating in multiple national markets, by locating in multiple national markets, the global competitor can cross-subsidize to attack nationally focused rivals. Need to access market trends and technological developments in each of the world’s major economic centers- N. America, Europe, EastAsia. } Ted Levitt “Global- -ization Thesis” Hamel & Prahalad Thesis Kenichi Ohmae’s “Triad Power” Thesis

28. Strategy and Organization of the MNC:The Evolution of Multinational Strategies and Structures : (1) Pre 2nd WW: Era of the Europeans The European MNC as Decentralized Federation : • National subsidiaries self-sufficient and autonomous • Parent control through appointment of subsidiaries senior management • Organization and management systems reflect conditions of transport and communications at the time e.g. Unilever, Phillips, Courtaulds, Royal Dutch/Shell.

29. Strategy and Organization of the MNC: The Evolution of Multinational Strategies and Structures: (2) Post 2nd WW: U.S. Dominance American MNC’s as Coordinated Federations : • National subsidiaries fairly autonomous • Dominant role as U.S. parent-- especially in developing new technology and products • Parent-subsidiary relations involved flows of technology and finance, and appointment of top management.e.g. Ford, GM, Coca Cola, IBM

30. Strategy and Organization of the MNC: The Evolution of Multinational Strategies and Structures: (3) 1970’s and 1980’s: The Japanese Challenge The Japanese MNC as Centralized Hub • Pursuit of global strategy from home base • Strategy, technology development, and manufacture concentrated at home • National subsidiaries primarily sales and distribution companies with limited autonomy. e.g. Toyota, NEC, Matsushita

31. Matching Global Strategies and Structures to Industry Conditions Degree of globalization depends upon the benefits of global integration versus the benefits of national differentiation. Key issue: --How important are global scale economies? --How different are customer requirements between countries? • Jet engines Benefits of global integration • Consumer • electronics • Telecommunications • equipment • Packaged • grocery products • Cement Benefits of national differentiation

32. Marketing Global Strategies and Situations to Industry Conditions: Firm Success in Different Industries Consumer Electronics Branded, Packaged Telecommunications Consumer Goods Equipment - Global industry - Substantial national - Requires both global - Matsushita the most differentiation, few global integration and national successful scale economies differentiation. - Philips the survivor - Kao has limited success - NEC only partially - GE sold out outside Japan successful - Unilever and P&G most - ITT sold out successful - Ericsson most successful Matsushita NEC Kao Erickson Philips global integration global integration global integration P&G Unilever General Electric ITT local responsiveness local responsiveness local responsiveness

33. Reconciling Global Integration with National Differentiation: The Transnational Corporation Tight complex controls and coordination and a shared strategic decision process. Heavy flows of technology, finances, people, and materials between interdependent units. The Transnational: an integrated network of distributed interdependent resources and capabilities. • Each national unit and source of ideas, skills and capabilities that can be harnessed to benefit whole corporation. • National units become world sources for particular products, components, and activities. • Corporate center involved in orchestrating collaboration through creating the right organizational context.