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Vertical Integration: Make, or buy?

Vertical Integration: Make, or buy?. What are the issues?. Technological. Strategic. Contractual. Organizational. In a dynamic context. Technological. The ability to partition the work may be critical (I can’t “buy” if I can’t split the work off).

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Vertical Integration: Make, or buy?

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  1. Vertical Integration: Make, or buy?

  2. What are the issues? Technological Strategic Contractual Organizational In a dynamic context

  3. Technological • The ability to partition the work may be critical (I can’t “buy” if I can’t split the work off) • But task boundaries, degree of modularity etc may be endogenous –a product of the history of competition and of each firm’s strategic choices, as well as “given by nature”

  4. Strategic • Avoid double marginalization • Control capacity • Generate complements • Control the evolution of interfaces

  5. Contractual If lawyers were free and contracts were perfect… BUT: Uncertainty Complexity Specialized assets create the incentive for “hold up”

  6. Organizational • What happens to “effort” – to creativity, to entrepreneurial drive, to initiative – once we integrate?

  7. Contracts , Organizations , and the Integration Decision

  8. Independent contractor Supplier Asset User The supplier has “residual control rights”

  9. Integrated firm Supplier Asset User The user has “residual control rights”

  10. Hold up by independent contractors Threat: “Now that you’ve made that investment in working with me -- let’s renegotiate...” Supplier Asset Result: Unwillingness to make “specific investments” In a supplier User

  11. Hold up within an integrated firm Threat: “We’ll pay you what you can get elsewhere” Supplier Asset Result: Employees reluctant to invest in employer specific assets User

  12. One – Shot Supply Relationships Independent contractor • What do the supplier’s incentives look like? Supplier • What will the supplier try to do? “Effort” Asset User (Value = P) Intermediate good User (Value = Q)

  13. One – Shot Supply Relationships Independent contractor What will happen if:

  14. One – Shot Supply Relationships: Integrated Firm • What do the employee’s incentives look like? Supplier • What will the employee try to do? “Effort” Asset User (Value = P) Intermediate good User

  15. Make, Buy or Cooperate? Can relational contracts Fix this problem? Supplier “Effort” Asset User (Value = P) Intermediate good User (Value = Q)

  16. Make, buy or cooperate: Using a repeated game $$$ “Cheat” – fail to pay Q, pay P instead Honor agreement: Pay Q Punishment Time

  17. What will make cooperation feasible? Low incentives to cheat  “A reputation to uphold” High incentives to cooperate The expectation of an enduring relationship The belief that the other guy understands “the nature of the game”

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