economic aspects in the management of a company
Outline the key economic aspects in the management of a company’s vertical chain. In your
answer examine the make-buy dilemma, agency costs and the relevance of specific assets
and incomplete contracts.
Introduction
The vertical chain initial chain commences with the acquisition of the company’s raw materials and
finally completes its circle with the sale of the company’s finished product. Vertical chain organization is
a critical function in business strategy. A company’s decision to purchase its products from an
independent producer or to manufacture it on its own is known as the make-or-buy decision. Make
applies that the company owns and performs the activity by itself while to buy means that the company
depends on another independent company to produce it under an agreed contract. The make or buy
decisions extend to the development of supplier sources, shipping services or even operating retail
services. Raw materials supplier may retail forward for instance when Nike Inc relocated its major
operations to Asia its suppliers had also to move with the company or risk losing out to other competitors.
Companies need to basically define their vertical boundaries. The outside specialists or producers who
can perform the vertical chain tasks are known as the market firms. Market firms are mostly recognized
natural leaders in the field. Companies outsource the major technical part of the production processes to
companies that are specialized. (Lafontaine and Slade 2007) For example, Nike outsourced its
manufacturing facility in Asia to a specialized firm. Others are like the UPS. These market firms have to
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be efficient and very innovative in the market in order for them to survive. Inefficiencies mostly lead to
cancellation of contracts hence they are subject to the discipline of the market. Other companies like
General Motors rely on such companies like Delphi and Lear to produce and supply vehicle parts for its
own use in its manufacturing processes. (Klein 1999)
Companies should make assets that have competitive advantage and outsourced the ones with less
competitive advantage. The advantage of buying is that the profit margin that accrues to market firms is
obtained when the company makes the products. Vertical integration however insures the company
against the risk of fluctuation of input prices. Making products also ties up the major distribution channels
and restricts access to competitors. Mergers are perfect examples of vertical integration. The economic
profit, which is largely refers to relative profitability than the accounting profit which relates to
company’s financial aspects only is more useful as when the upstream supplier is making enough profits
financially it may not be economical in the long run. It would be better when the manufacturer
downstream is making economic profit in the long run by internalizing the production activities.
Company X vertical integration for Lumber (Processed Timber)
Non
integration
and the
Company X Lumber
prize
Vertical
Int
3000 5000 7000
Revenue 1,000,000 1,000,000 1,000,000 1,000,000
Cost of Goods
Sold
Lumber 150,000 300,000 500,000 700,000
Assembly 400,000 400,000 400,000 400,000
Total 550,000 700,000 900,000 1,000,000
Interest Exp 350,000
Profit 100,000 300,000 100,000 -100,000
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The framework between the principal and the agent is applicable even to employees as their actions have
an impact on the owner’s payoff. An agent in economics represents an entity in informal or formal
agreements or contracts to provide goods or services, resources to other entities or principal in exchange
of an reward. The employer guards against any slack work or any other abuse of the company’s resources
which eventually add up as the agency’s costs and which may be related to the incompetencies of the
agents. These costs may be influence or innovation problems. Influence costs may occur when the
company decides to produce a particular input because it cannot be produced elsewhere in the same way
and precisely as it’s produced by the company. For example the company uses a manufacturing soft ware
that they alone have it. The company’s employee may be having a skill that the other producers don’t
have. The company may also not have the power over such employees and it may want to reward itself
together with the innovative employees. Innovative costs are incurred when certain employees like
scientists are rewarded with positions in the company instead of allowing them to change jobs in an effort
to exploit their talents. The company can decide to incur agency costs instead of losing the employee to
its competitors.
The major reasons to manufacture or make products is that it’s cheaper to coordinate a number of people
during the production stage inside a company and it will save on time, size and quantity of production,
color and sequence as per coordination costs. The major reasons to make a product are the organization
and the transaction costs involved in exchanges that are between arms-length in the company’s
marketplace. These costs refer to writing, contract negotiation and enforcement which consumes a lot of
managements time.
Companies mostly have private and sensitive information about the company’s innovation, sales and
financial strategies. It’s easier to induce employees to remain silent that allowing the company’s
innovative details to be shared outside the company. For example, coca cola’s secret formulas have
remained confidential to date because of its own strategies. A firm can only decide avoid the costs of
making the products largely on the basis of its price, quality and other issues that may influence its costs.
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The objective of the company should to capture the profits which are dependent on the company’s cost
structure. The company should also be assured of its suppliers to avoid unnecessary price fluctuations or
use the futures market to maintain price stability.
The major problem that affects most economic organizations in their management is generally motivation
problems. These problems originate from individual private interests which may not be aligned to the
company’s interests. Coordination problem is basically to determine who should perform which task and
make what decisions based on which information. Motivation problem occurs when individuals placed in
authority are willing to perform their tasks willingly with the company’s interest. They need to be
motivated to coordinate the groups. To manage different individual interests, a contract should be drawn
that modifies individual behaviors in ways that both the company and the individual benefits. The
company can motivate to coordinate the company’s resources through the use of contracts but complete
contracts rarely exists hence the motivation problem.
Asset specificity relates to the nature of a transaction inter-party relationship. It’s the way an investment
is structured to support and accommodate certain transactions that have higher values only on that
transaction and the results are much lower if the same resources are allocated to another transaction.
(Klein, Frazier and Roth 1990) Specific assets are very profitable in certain specific settings while co-
specialized assets are most profitable when used together with others than when they are their own as they
lose most of their value when they are used separately. (Besanko, Dranove, Shanley and Schefer 2010)
For example, an electric power plant and a coal mine. Both the mine and also the power plant are assets
that are co-specialized whereas the mine depends on the power plant as the single supplier the mine is the
only customer for the power plant.( assuming there are no other plants or power plants nearby) (Joskow
1985)
A hold-up situation arises where parties to a contract are generally worried that they may be compelled to
accept lower or disadvantageous terms during the later years of a contract when the investment has
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already been made. (Joskow 1988) The specificity of assets coupled with imperfect contracting are the
main recipes for hold-up issues. For example, two companies X and Y have made relationship specific
investments costing $2 each while the investments gross return is $8. Each of the parties can opt for
opportunistic actions, if the other does not, he ends up with the all the rent. The payoff matrix is therefore
illustrated below.
Payoff Matrix for Firm X & Y
Firm
Y
Grab
Don’t
Grab -1 –
1
3 -2
Firm X
Don’t -2 3 2 2
NE indicates that the results as -1,-1 while both parties will generally grab the opportunity. It’s a case
that’s similar to a prisoner’s dilemma only that each party of the contract can opt out of the investment if
possibilities of imminent opportunisms activities are real.
Contractual incompleteness can be rectified by relational and also other implicit contracts, vertical
integration, reputations and commitment. The value of a reputation largely depends on each transaction’s
profitability, the horizon of expected similar activities and finally the frequency of similar transactions in
future.
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References
Besanko, D., Dranove, D., Shanley, M. and Schefer, S., 2010, Economics of strategy, New York, John
Wiley & Sons
Joskow, P. L., 1985, “Vertical Integration and Long-Term Contracts: The Case of Coal Burning
Electric Plants”, Journal of Law, Economics and Organization, 1985, pp. 33–80.
Joskow, P. L., 1988, “Asset Specificity and the Structure of Vertical Relationships: Empirical
Evidence”, Journal of Law, Economics and Organization (4), spring, pp. 95–117.
Klein, B., 1999, “Vertical Integration as Organizational Ownership: The Fisher Body – General
Motors Relationship Revisited”, The Journal of Law, Economics and Organization,
pp. 199–213.
Klein, S., Frazier, G., and Roth, V. J., 1990, “A Transaction Cost Analysis Model of Channel
Integration in International Markets”, Journal of Marketing Research, pp. 196–208.
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Lafontaine, F. and Slade, M.E., 2007, Vertical integration and firm Boundaries, the evidence.
Journal of Economic Literature, Vol. 45
