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Vertical Chain

Vertical Chain. Vertical Integration. The degree to which the firm controls the chain. Vertical Integration. Upstream Integration – towards raw materials. Vertical Integration. Downstream Integration – towards end customer. Boundaries of the Firm.

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Vertical Chain

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  1. Vertical Chain

  2. Vertical Integration The degree to which the firm controls the chain.

  3. Vertical Integration Upstream Integration – towards raw materials

  4. Vertical Integration Downstream Integration – towards end customer

  5. Boundaries of the Firm The question for a firm is “Where to draw the boundary.” The answer is closely tied to material in CH 3. Expanding is integrating Contracting is outsourcing

  6. Outsourcing • South Park – “They took our jobs” http://www.gofish.com/userVideoPlayer.gfp?gfid=30-1015163 • Dell expanding in India - http://www.nytimes.com/2006/03/21/technology/21dell.html?adxnnl=1&adxnnlx=1143497181-q6B42De9MThtS0g2ZNxwqA • The Dubai Ports deal. http://www.cnn.com/2006/POLITICS/03/09/port.security/ • A guide to best practice by Accenture: http://www.accenture.com/xdoc/en/services/outsourcing/ps/global/landing_ps.pdf

  7. Should a firm vertically integrate? Pros of doing it in-house Avoid double markup problem Upstream Firm: MC=10 and No Fixed Cost Downstream Firm: P= 110-Q, MR=110-2Q Only cost to D is price set by U

  8. Double Mark Up Problem What will MC to D look like? Given a price set by U, what quantity will D buy? $/q PD MCU MRD q

  9. Double Mark Up Problem $/q So MRD=PUMRU=110-4Q What quantity will be traded? How much will each firm earn? PD MCU MRU MRD=PU q

  10. Double Mark Up Problem $/q Profits U: 50x25=1250 Profits D: 25x25= 625 PD = 85 PU = 60 PD MCU MRU MRD=PU q QD =25

  11. Double Mark Up Problem with Vertical Integration Profits: 50x50 = 2500 & Consumer Surplus Increased $/q P= 60 P MC MR Q=50 q

  12. Other ways to Avoid Double Mark-up Resale Price Maintenance: Up stream firm sets price that downstream firm can charge. Manufactures Suggested Retail Price (MSRP). Two-part Tariff

  13. Should a firm vertically integrate? Pros of doing it in-house No Hold Up Problem ex: U invests ($5M) in equipment and training to produce component (MC= $1) specific to D. The investment becomes a sunk cost for U. D could offer only $2 on 1M units. U would take it as it increases profits, but overall U earns a loss. Therefore, U is hesitant of undertaking this investment.

  14. Should a firm vertically integrate? Pros of doing it in-house Minimize Supply Disruptions Reduced Externalities Monitoring Quality Lower Contracting and Transaction Costs Taxes and Regulation Centralized Decision Making

  15. Should a firm vertically integrate? Pros of outsourcing Flexible Economies of Scale Specialized Knowledge Decentralized Decision Making Focus on Core Competencies

  16. Integration vs Outsourcingchoosing along a continuum

  17. Asset specificity, uncertainty, and the procurement decision

  18. Other Vertical Relationships Hybrid Arrangements Strategic Alliances Long Term Contracting Joint Ventures

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