Advanced Corporate Strategy

ST104x

Mitigate holdup risk

Let us first start by looking at the advantages of market-based transactions. Let us compare
‘buying’ from an independent supplier with ‘making’ using an internal supplier.

I. First, an independent supplier can achieve higher economies of scale because it can
sell to multiple buyers compared to an internal supplier of a component. An internal
supplier can sell to others as well but that leads to other complications, as we will
discuss later.

II. Second it is easier to provide high powered incentives in markets as compared

to procurement from an internal supplier. To put it very simply may be even
simplistically it is easier to fir a supplier than an employee. Since incentives work much
better in markets, an outside supplier is likely to have either lower costs or higher
quality.

Given these advantages, when does “make” perform better than “buy”?

Make outperforms buy when there are transaction-specific investments. These are
investments that are valuable for a specific transaction but less useful for other transactions.
For example, a component supplier for an automobile manufacturer makes an investment in
a machine for making a very specific component that the automobile manufacturer requires.
Suppose this machine cannot be used for making components for any other manufacturer.
This machine has high asset specificity and results in what is called as a holdup.

Let us say that the component supplier made the investment believing that the automobile
manufacturer would buy from them for a particular price. But once the investment in the
machine is made, the automobile company can demand a lower price. Given that the machine
has no use elsewhere, the component supplier has no alternative but to accept the lower
price. Thus, the automobile manufacturer can holdup the component supplier.

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 Advanced Corporate Strategy

ST104x

You could argue that the component supplier and the automobile manufacturer can enter
into a contract and fix the price for all future transactions. But such contracts do not work
because it is not possible to write a complete contract that can handle all possible scenarios
given the level of uncertainty that exists about the future. For example, it is difficult to
forecast steel prices or who is likely to win an election and how the elected candidate is likely
to govern.

So, uncertainty implies that contracts will remain incomplete and they will not provide
protection against holdup. Now the component supplier knows that a transaction-specific
investment can lead to holdup and hence is likely to not make the investment in the first
place. In such a scenario, the automobile company has to make the component by itself and
become backward integrated.

Thus, vertical integration can mitigate holdup risk and is likely to perform better
than procuring from the market when transaction-specific investments are required.

© All Rights Reserved, Indian Institute of Management Bangalore