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Some Make-or-Buy Fallacies

Before detailing the critical determinants of make-or-buy decisions, we need to dispense with five common, but incorrect, arguments:

1.Firms should make an asset, rather than buy it, if that asset is a source of competitive advantage for that firm.

2.Firms should buy, rather than make, to avoid the costs of making the product.

3.Firms should make, rather than buy, to avoid paying a profit margin to independent firms. (This fallacy is often expressed this way: “Our firm should backward integrate to capture the profit of our suppliers for ourselves.”)

4.Firms should make, rather than buy, because a vertically integrated producer will be able to avoid paying high market prices for the input during periods of peak demand or scarce supply. (This fallacy is often expressed this way: “By vertically integrating, we obtain the input ‘at cost,’ thereby insuring ourselves against the risk of high-input prices.”)

5.Firms should make, rather than buy, to tie up a distribution channel. They will gain market share at the expense of rivals. This claim has merit on some occasions, but it is used to justify acquisitions on many other occasions when it lacks merit.

Though widely held, the first argument is easy to reject. An asset that is easily obtained from the market cannot be a source of advantage, whether the firm makes it or buys it. If it is cheaper to obtain an asset from the market than to produce it internally, the firm should do the former.

The second argument, which stems from the mistaken belief that the correct make-or-buy decision can eliminate steps from the vertical chain, is also easy to reject. Consider an activity on the vertical chain, say, the distribution of finished goods from a manufacturer to retailers. Choosing to buy, rather than make, does not eliminate the expenses of the associated activity. Either way, someone has to purchase the trucks and hire the drivers. And either way, the firm will pay the cost. Once again, if the firm can perform the activity at a lower cost than it takes to buy it from the market, it should do so. But firms often take a look at market prices and the apparent profitability of market firms and fool themselves into thinking they can make at a lower cost. This is the third fallacy.

There are two potential flaws in the third fallacy. The first flaw stems from the difference between accounting profit and economic profit discussed in the Economics Primer. Accounting profit is the simple difference between revenues and expenses. Economic profit, by contrast, represents the difference between the accounting profits from a given activity and the accounting profits from investing the same resources in the most lucrative alternative activity. Because economic profit speaks to the relative profitability of different investment decisions, it is more useful than accounting profit when making business decisions. Even if an upstream supplier is making accounting profits, this does not imply that it is making economic profits or that a downstream manufacturing firm could increase its own economic profits by internalizing the activity.

But suppose the upstream supplier is generating substantial positive economic profits. The downstream manufacturer might believe that it could make at a cost below the “exorbitant” supply price. Before doing so, however, the manufacturer should ask a critical question: “If the supplier of the input is so profitable, why don’t other firms enter the market and drive the price down?” Perhaps it is difficult to obtain the expertise needed to make the desired input, or maybe the existing supplier

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is the only one large enough to reap economies of scale. In these circumstances, the manufacturer would likely find it cheaper to pay the supplier’s high price rather than make the input itself.

Avoiding Peak Prices

To illustrate the subtle issues raised by the fourth fallacy, consider a fictitious manufacturer of log homes, Honest Abe Log Homes. Honest Abe sells log cabins that it assembles from specially milled lumber. The market price of this lumber varies from year to year, and for this reason, Rustic’s managers are contemplating backward integration into the raising and milling of trees. This is a tempting but fallacious reason for vertical integration.

To see why, suppose that Honest Abe sells its log cabins for $30,000 each. Besides the costs of milled lumber, it incurs $12,000 in labor costs for every cabin it assembles. During the next year, Honest Abe has 100 confirmed orders for log cabins. It contemplates two options for its raw materials needs:

1.It can purchase lumber in the open market. Honest Abe believes that there is a chance that the price of the lumber needed to build one cabin will be $21,000, a chance that the price will be $15,000, and a chance that the price will be $9,000.

2.It can backward integrate by purchasing forest land and a lumber mill. To finance the purchase, Honest Abe can obtain a bank loan that entails an annual payment of $1,050,000 (or $10,500 per cabin). In addition, the cost of harvesting timber and milling it to produce the finished lumber for one cabin is $4,500. Thus, the effective cost of timber would be $15,000 per cabin.

Table 3.2 illustrates Honest Abe’s annual income under these options. Under the vertical integration option, Honest Abe has an assured annual profit of $300,000. Under the nonintegration option, its net income is uncertain: it could be $900,000, it could be $300,000, or it could be 2$300,000. The expected value of this uncertain income is $300,000.5

Even though the vertical integration and nonintegration options entail the same expected profit, it is tempting to argue in favor of vertical integration because it eliminates Honest Abe’s risk of income fluctuations. This is an especially tempting argument if management is concerned that when lumber prices are high ($21,000), Honest Abe will not have enough cash to cover its loss and thus will go

TABLE 3.2

Rustic Log Homes

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bankrupt. If Honest Abe is committed to being an ongoing business concern, according to this argument it should vertically integrate to eliminate the risk of being unable to pay its bills.

Honest Abe does not, however, need to vertically integrate to eliminate its income risk. It could counteract price fluctuations by entering into long-term (i.e., futures) contracts with lumber suppliers or by purchasing lumber futures contracts on the Chicago Mercantile Exchange (CME). Examples of other inputs hedged on the CME include natural gas, soybeans, copper, and oil. Even if Honest Abe could not hedge, the argument for vertical integration is still flawed. After all, if Honest Abe could raise the capital to purchase the forest land, it could instead create a capital reserve to weather short-term fluctuations in lumber prices (e.g., perhaps through a line of credit from the same bank that was willing to loan it the money to buy the land and the lumber mill).

Tying Up Channels: Vertical Foreclosure

Integration to tie up channels is known as vertical foreclosure. Using our upstream/ downstream terminology, we can envision four ways for a firm to foreclose its rivals.

1.A downstream monopolist acquires an upstream firm and refuses to purchase from other upstream suppliers.

2.An upstream monopolist acquires a downstream competitor and refuses to supply other downstream firms.

3.A competitive downstream firm acquires an upstream monopolist and refuses to supply its downstream competitors.

4.A competitive upstream firm acquires a downstream monopolist and refuses to purchase from its upstream competitors.

In each of these scenarios, foreclosure extends monopolization across the vertical chain and therefore seems to increase profits.

Foreclosure can increase profits but not for the seemingly obvious reasons. One danger of this strategy is that competitors may open new channels. A second danger specific to scenarios (3) and (4) is that the competitive firm will have to pay a steep fee to acquire a monopolist. The acquirer could still prosper if the merger increases the total profits available in the vertical chain. But this is impossible according to an argument associated with the Chicago School of Economics, an argument that also sheds doubt on the profitability of scenarios (1) and (2).

Noted French economic theorists Patrick Rey and Jean Tirole sum up the Chicago School argument as follows:

The motivation for foreclosure cannot be the desire to extend market power, since there is a single final product and thus a single monopoly profit.6

In other words, only so much money can be squeezed out of consumers—the monopoly profit. A firm that monopolizes a single stage in the vertical chain, sometimes said to create a bottleneck in the vertical chain, can command that monopoly profit in its entirety. Vertical integration cannot increase profits above the monopoly profit, and therefore there is no reason to foreclose. Because integration cannot increase monopoly power, the Chicago School argument concludes that the courts should ignore vertical integration between a monopolist and another firm. (A variant of this argument applies to horizontal integration.)

It turns out that the Chicago School argument is about half right.7 There is only so much profit to be squeezed from the vertical chain, and foreclosure does not increase the available profit. But in some situations foreclosure may still be profitable,