4- The Make or Buy Decision

Managers make many decisions that affect the horizontal and vertical dimensions of a firm’s
organization.

Horizontal dimension Vertical dimension

Refers to the size of the firm in its Refers to the various stages of the production
primary market process in which the firm participates.

 To produce a good and sell it to consumers involves many sequential stages of production, marketing, and
distribution activities.
 A manager must decide how many stages the firm itself will undertake.

 At each stage, a manager chooses whether to carry out the activity within the firm or to pay for it to be done by
others.

 Deciding which stages of the production process to handle internally and which to buy from others is part of
what is referred to as supply chain management.
 Stages of Production
In the nineteenth century production often took place along a river. Early stages of production occurred upstream,
and then the partially finished goods were shipped by barge downstream
Upstream refers to earlier stages of production and downstream refers to later stages.

 Vertical Integration
A firm that participates in more than one successive stage of the production or distribution of goods or services is
vertically integrated.

o A firm may vertically integrate backward and produce its own inputs. For example, after years of buying its unique
auto bodies from Fisher Body, General Motors purchased Fisher in a vertical merger.

o Or a firm may vertically integrate forward and buy its former customer. At different times, the car manufacturers
General Motors and Ford have owned Hertz, the first car-rental company

 The alternative to a firm producing an input or activity itself is to buy

 Increasingly, many firms reach agreements with other firms to buy services from them on a continuing basis, a practice
called outsourcing.

 A firm can be partially vertically integrated. It may produce a good but rely on others to market it. Or it may
produce some inputs itself and buy others from the market.
Quasi-Vertical Integration.
Some firms buy from a small number of suppliers or sell through a small number of distributors. These firms often control
the actions of the firms with whom they deal by writing contracts that restrict the actions of those other firms. These
contractual vertical restraints approximate the outcome from vertically merging. Such tight relationships between firms
are referred to as quasi-vertical integration.

A manufacturer that contracts with a distributor to sell its product may place vertical restrictions on the distributor’s
actions beyond requiring it to pay the wholesale price for the product. These vertical restrictions are determined through
contractual negotiations between the manufacturer and the distributor. The manufacturer imposes these restrictions to
approximate the outcome that would occur if the firms vertically integrated. Examples of restrictions include requirements
that the distributor sell a minimum number of units, that distributors not locate near each other, that distributors not sell
competing products, and that distributors charge no lower than a particular price.
Contracts Versus Spot Markets
Even if a company does not use the detailed contracts needed for quasi-vertical integration, it may sign long-term
contracts that provide some of the features of vertical integration.

For example, a furniture maker might enter into a multi-year contract to buy some specific annual quantity of
wood from a lumber company at a fixed price. The furniture maker can rely on a steady supply of wood at an
affordable price, just as it would if it produced its own lumber in a vertically integrated structure.

Spot market or Cash market

If the furniture firm does not sign a long-term contract and does not vertically integrate, it buys lumber as it needs
it at the current price from a variety of lumber yards. an organized market that sells commodities for immediate
delivery
 5- Market Structure
Market Structure. A firm’s profit depends in large part on the market structure, which reflects the number of firms in the
market, the ease with which firms can enter and leave the market, and the ability of firms to differentiate their products from
those of their rivals.
The major market structures are perfect competition, monopoly, oligopoly, and monopolistic competition.
Competitive firms are price takers, whereas others are price setters.
Oligopolies and monopolistically competitive firms, unlike competitive firms and monopolies, must take account of rivals’
strategies and may differentiate their products.
THE FOUR MAIN MARKET STRUCTURES

Most industries fit into one of four common market structures: perfect competition, monopoly, oligopoly, and
monopolistic competition.
 Perfect Competition
 Monopoly
 Oligopoly
 Monopolistic Competition
 PERFECT
COMPETITION

When most people talk about competitive companies, that’s This refers to companies that form competitors for
the same customers. According to this interpretation, each market Compete with more than one company.
However, economists often use“ Competition" refers to a market that satisfies the conditions of perfect
competition Economists say that when every firm does this, the market is in a state of perfect competition
Price Taker: A company that cannot significantly influence the market price of its product or products The
price at which inputs are purchased. Firms may become price takers in the market Where all companies sell
the same products, companies can come and go freelyIn the long run, all buyers and sellers know the price
charged by the company, And transaction costs are low. If one of the 26,000 tomato producers in the U.S.
Countries should stop production or double production, market price of tomatoes
Monopoly

A monopoly is the sole supplier of a good that has no close substitutes. DE Beers until recently controlled the global
diamond market. Monsanto has one Monopolizes many genetically modified (GM) seeds. Many local municipal utilities such
as: Because cable TV companies are local monopolies. Patents give monopoly rights Selling inventions, such as certain drugs
or genetically modified seeds. The company can be A monopoly exists if its costs are significantly lower than those of other
potential firms.
 Oligopoly

Oligopoly is a market with only a few larger companies Market entry barriers prevent other firms from entering the market.
There may be barriers to entry It could be that state licensing laws limit the number of companies or patents that prevent this
Prevent other companies from using low-cost technology. It's Nintendo, Microsoft and Sony An oligopoly of companies that
dominate the video game market. only a few companies Control markets for cars, televisions and air planes.
Since relatively few companies compete in an oligopolistic market, each company can have influence price. One of the
reasons oligopoly determines prices is that there are many oligopolies Differentiate their products from those of their
competitors. because consumers Noting the Differences Between the Honda Accord and Toyota Camry Can Attract Toyota
Make the price of his Camry higher than the price of the Accord without losing all sales. Some Customers who prefer the
Camry to the Accord will buy the Camry even if it's a bit pricey Not just an agreement.
 Monopolistic Competition

Monopolistic competition is a market structure Which companies are price makers, but getting started is easy. It's like a
monopoly or an oligopoly There are only a few companies in the market, so each company can influence the price. In fact,
Competitive companies often differentiate their products, which makes it easier for them to do so Become a price setter.
However, as in competition, firms are free to enter, subject to boundary conditions The company does not generate any
economic profit.
 SECURITY AND FLEXIBILITY OF SUPPLY

• Backward Integration
Backward integration is when a company integrates with its suppliers or sources of raw materials.

• Benefits of Backward Integration

o Supply Security: By integrating with suppliers, a company can ensure a steady and reliable supply of
inputs.
o Cost Control: Backward integration can help reduce costs by eliminating the need to rely on external
suppliers and their pricing.
o Quality Control: Integrating with suppliers allows for better control over the quality of inputs,
leading to improved product quality.
 QUASI-VERTICAL INTEGRATION

• Benefits of Quasi-Vertical Integration

 Timely arrival of parts is ensured through a contract between the buyer and seller.
 Rewards are given for prompt delivery, encouraging suppliers to meet deadlines.
 Penalties are imposed for delays, incentivizing suppliers to prioritize timely delivery.
 JUST-IN-TIME SYSTEM

• The just-in-time system is a method used by companies to minimize inventory costs and avoid
bottlenecks in the production process.
• In this system, suppliers deliver inputs at the exact time they are needed to be processed,
eliminating the need for excessive inventory and reducing storage costs.
• The just-in-time system ensures that production processes are efficient and streamlined, with
minimal waste and idle time.
• By receiving inputs just in time, companies can respond quickly to changes in demand and adapt
their production accordingly.
 FLEXIBILITY THROUGH VERTICAL
INTEGRATION
• Increased Control
 Vertical integration allows firms to have direct control over the entire supply chain, from raw materials to the final
product.
 This control enables firms to quickly adjust production levels and respond to changes in demand or market conditions.
• Efficient Communication
 Vertical integration allows for seamless communication and coordination between different stages of the production
process.
 This improves efficiency and reduces the risk of miscommunication or delays
• Cost Savings
 Vertical integration can lead to cost savings by eliminating the need to rely on external suppliers or vendors.
 This can result in lower production costs and increased profitability.
 EXAMPLE: PEPSICO INC.

• Benefits of Vertical Integration

 Significant cost synergies
 Improved decision making speed
 Increased strategic flexibility
• Example: PepsiCo Inc.
 PepsiCo Inc. is a prime example of the benefits of vertical integration.
 The company has achieved significant cost synergies by integrating its supply chain from sourcing raw materials to
manufacturing and distribution.
 Vertical integration has enabled PepsiCo Inc. to make faster and more informed decisions, leading to improved operational
efficiency.
 The company's vertical integration also provides strategic flexibility, allowing it to adapt quickly to changing market
conditions and consumer preferences.
 BACKWARD VERTICAL INTEGRATION IN
THE ALUMINUM INDUSTRY
 The aluminium industry commonly employs backward vertical integration as a strategic
approach to mitigate the risk of opportunistic behavior.
 By integrating backward into the supply chain, aluminum companies can secure their access to
key raw materials and reduce dependency on external suppliers.
 Backward vertical integration allows aluminum companies to have greater control over the
quality, cost, and availability of raw materials.
 Integration into the upstream supply chain enables aluminum companies to streamline
production processes, improve efficiency, and reduce costs.
 AVOIDING GOVERNMENT INTERVENTION

• Price Controls
 Vertical integration allows firms to have more control over pricing, avoiding government-imposed price
controls that may limit profitability.
• Taxes
 By vertically integrating, firms can strategically structure their operations to minimize tax liabilities and
take advantage of tax incentives.
• Regulations
 Vertical integration allows firms to have more control over compliance with regulations, reducing the
risk of government penalties and restrictions.
 SHIFTING PROFIT TO LOWER TAXES

• Vertical Integration and Tax Optimization

 Vertical integration allows firms to shift profit from one division to another.
 By allocating expenses and revenue across divisions, firms can optimize their tax liabilities.
 This strategy helps lower taxes by leveraging differences in tax rates between divisions.
 GOVERNMENT REGULATIONS AND VERTICAL
INTEGRATION

 Government regulations can have a significant impact on the decision of firms to integrate vertically.
 Regulations may create incentives for firms to integrate vertically in order to avoid restrictions on
regulated divisions.
 Vertical integration can provide firms with more control over their supply chain and ensure security and
flexibility in the face of government regulations.
 By integrating vertically, firms can streamline their operations, reduce costs, and improve efficiency.
 Vertical integration also allows firms to take advantage of economies of scale and market size, leading
to increased market power and competitiveness.
 MARKET SIZE AND DIVISION OF LABOR

• Advantages of Market Size

 Larger market size allows for economies of scale, leading to lower production costs.
 Increased market size provides opportunities for higher sales volume and revenue growth.
• Advantages of Division of Labor
 Specialization in specific tasks allows for increased efficiency and productivity.
 Workers can focus on their areas of expertise, leading to higher quality output.
The Division of Labour and Specialization
 SPECIALIZATION AND HENRY FORD

• Henry Ford utilized specialization and mass production techniques to become a successful
automobile manufacturer. He implemented the conveyor belt and assembly line to produce
standardized, inexpensive cars through a series of specialized tasks performed by individual
workers.
• Henry Ford's Specialization Techniques
 LIMITATIONS OF SPECIALIZATION

• Extent of the Market

 Adam Smith argued that a firm can only take advantage of specialization and economies of scale
if it produces a sufficiently large amount of output.
 The extent of the market determines the demand from consumers, which in turn affects the
ability of firms to specialize.
 THE LIFE CYCLE OF FIRMS

• Stigler and Williamson's Research

Stigler and Williamson's research on the life cycle of firms explains why firms rely on markets
during certain periods and vertically integrate during others.
• Integration and Market Size
The degree of integration depends on the size of the market. When demand for a product is low and
the collective output of all firms in the industry is small, each firm must undertake all activities
associated with producing the final output itself.
 VERTICAL INTEGRATION

 Vertical integration occurs when firms specialize in making one or several inputs that they then
sell to another firm for use in assembling the final product.
 The decision to vertically integrate depends on the size of the market.
 In a small industry, it does not pay for a firm to specialize in one activity as the average fixed
cost per unit is large.
 As the industry expands, firms vertically disintegrate and buy services or products from
specialized firms.
TRANSACTION COSTS AND SPECIALIZATION

• Transaction costs play a crucial role in the decision to specialize in a particular industry. As the industry grows, per-
unit transaction costs decrease, making it more profitable for firms to specialize in specific tasks or functions.
Specialization allows firms to focus on their core competencies, leading to increased efficiency and productivity.
• However, when an industry shrinks in size, firms may choose to vertically integrate again. Vertical integration refers
to the merging of different stages of production or distribution under a single ownership. This decision to integrate
can be driven by the desire to reduce transaction costs and maintain control over the entire production process.
• The choice between specialization and integration depends on various factors, including market conditions and the
behavior of rival firms. In highly competitive markets with low barriers to entry, firms may choose to specialize to
gain a competitive advantage and differentiate themselves from competitors. On the other hand, in industries with
high barriers to entry or limited competition, firms may opt for vertical integration to secure their market position
and protect their interests.
 INDUSTRY MATURATION AND VERTICAL
INTEGRATION
• Industry Maturation
As an industry matures, new products may develop and reduce demand for the original product,
causing the industry to shrink.
• Vertical Integration
Firms may vertically integrate again in response to these changes.
• Specialization vs Integration
The decision to specialize or integrate depends on the market conditions and the behaviour of rival
firms.
 BEHAVIOR OF RIVAL FIRMS

• Market Structure and Firm Behaviour

The behaviour of rival firms has a significant impact on a firm's profit. Managers must carefully
consider how their firm's profit is affected by factors such as rival firms' output levels, prices, and
the potential entry of new firms into the market. The behavior of firms is influenced by the market
structure in which they operate, including the number of firms, ease of entry and exit, and the
ability to differentiate products from rivals.
MARKET STRUCTURE AND FIRM BEHAVIOR

• Influence of Market Structure

The market structure, including the number of firms, ease of entry and exit, and the ability to
differentiate products, influences firm behavior.
• Different Behaviour in Different Market Structures
A firm's behaviour will differ depending on whether it is one of many firms in the market or the
only firm.
• Competitive Dynamics
The behaviour of firms is shaped by the competitive dynamics of the market.
DEGREES OF VERTICAL INTEGRATION IN
FIRMS
 EXAMPLES OF OUTSOURCING

• In the computer retail industry, many companies choose to outsource certain tasks and purchase
products from various sources. This allows them to focus on their core competencies and benefit
from the expertise and efficiency of external suppliers.
 EXAMPLES OF EXTENSIVE INTEGRATION

• In the broiler chicken industry, firms like Tyson and Purdue have implemented extensive vertical
integration strategies. These companies have integrated into nearly every production stage, from
breeding and hatching to processing and distribution. By controlling the entire supply chain,
these firms are able to achieve economies of scale and ensure quality control throughout the
production process.
 NO FIRM IS ENTIRELY SELF-SUFFICIENT

• No firm can operate in complete isolation. Even companies that strive for self-sufficiency, like
Foster Farms, rely on external inputs for their operations.
• To illustrate this point, let's consider the analogy of making an apple pie from scratch. While it
may be possible to grow the apples in your own orchard, you would still need to rely on external
sources for other ingredients like flour, sugar, and spices. Similarly, firms may try to vertically
integrate and control every aspect of their production process, but they will still need to rely on
external suppliers for certain inputs.
 TRADE-OFF IN VERTICAL INTEGRATION

• Larger and More Complex Structures

Firms face a trade-off in vertical integration, as larger and more complex structures may increase
managerial costs.
• Not All Firms Choose Extensive Integration
Despite the potential to reduce transaction costs, not all firms choose extensive integration.
 MANAGERIAL COSTS

• 💰 Increased Complexity
Larger and more complex structures may increase managerial costs.
 TRANSACTION COSTS

• Bypassing Negotiation Costs

Integrating firms can bypass the costs and delays associated with negotiating contracts with
external suppliers and customers.
• Improved Efficiency
Vertical integration can lead to improved coordination and communication between different stages
of the production process, resulting in increased efficiency.
 IMPORTANCE OF INTEGRATING FIRMS

• Reducing Transaction Costs

Integrating firms can help reduce transaction costs associated with coordinating activities between different
entities.
By bringing activities in-house, firms can streamline operations and avoid the need for complex contracts and
negotiations.
• Preventing Opportunistic Behaviour

Integrating firms can help prevent opportunistic behavior by aligning incentives and reducing the need for reliance
on external parties.
By controlling the entire value chain, firms can mitigate the risk of suppliers or partners acting in their own self-
interest.
 BENEFITS OF INTEGRATION

• Reduced Transaction Costs

Integration can lead to lower transaction costs by reducing the need for external transactions and
negotiations.
• Improved Efficiency
Integration allows for better coordination and communication between different stages of the
production process, leading to increased efficiency.
• Prevention of Opportunistic Behaviour
Integration can reduce opportunistic behaviour by aligning the interests of different stages of the
production process.