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Primer that a firm with market power sets its price above marginal costs. Double marginalization results when an upstream supplier exploits its power by marking up prices above marginal costs, and the downstream buyer exploits its own power by applying yet another markup to these already marked-up supply prices. This “double markup” causes the price of the finished good to exceed the price that maximizes the joint profits of the supplier and buyer. (As explained in the Economics Primer, a firm with market power can charge a price that is so high that its profits fall.) Through integration, the downstream firm can base its markup on the actual marginal costs of production, rather than the artificially inflated supply prices set by the independent supplier. In this way, the integrated firm uses just the right amount of market power and maximizes its profits. Although the concept of double marginalization receives considerable attention in microeconomics textbooks, very few mergers appeared to be undertaken to address this problem.
ALTERNATIVES TO VERTICAL INTEGRATION
There are a variety of alternatives between “make” and “buy.” In this section we consider four “hybrid” ways of organizing exchange: (1) tapered integration, in which the firm both makes and buys a given input; (2) franchising; (3) strategic alliances and joint ventures; and (4) close-knit semiformal relationships among buyers and suppliers, often based on long-term implicit contracts that are supported by reputations for honesty, cooperation, and trust. Each of these alternatives offers a different way to assign ownership and control of assets and creates distinct governance mechanisms. Thus, each offers a distinct resolution of the various trade-offs in the make-or-buy decision.
Tapered Integration: Make and Buy
Tapered integration represents a mixture of vertical integration and market exchange. A manufacturer might produce some quantity of an input itself and purchase the remaining portion from independent firms. It might sell some of its product through an in-house sales force and rely on an independent manufacturers’ representative to sell the rest. Examples of tapered integration include such retailers as Tim Hortons (a Canadian chain known for its coffee and donuts) which owns some of its retail outlets but also awards franchises; Coca-Cola and Pepsi, which have their own bottling subsidiaries, but also rely on independently owned bottlers to produce and distribute their soft drinks in some markets; and BMW, whose Corporate Center Development staff conducts market research but also purchases market research from independent firms.
Tapered integration offers several benefits. First, it expands the firm’s input and/ or output channels without requiring substantial capital outlays. Second, the firm can use information about the cost and profitability of its internal channels to help negotiate contracts with independent channels. Third, the firm can motivate its internal channels by threatening to expand outsourcing, and at the same time motivate its external channels by threatening to produce more in-house. Finally, the firm can protect itself against holdup by independent input suppliers.
Oil refiners provide a classic example of tapered integration. The refinery capacity of the largest companies, such as Exxon Mobil and Shell, greatly exceeds the amount of oil they recover from their own wells. As a result, they make substantial purchases
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EXAMPLE 4.4 FRANCHISE HEAT IN CHINA
Franchising is a relatively new business model. The first Kentucky Fried Chicken franchise opened in 1930. Dunkin’ Donuts, McDonald’s, and Burger King all started in the 1950s. Franchising was not introduced in China until the late 1980s, and until recently individually owned franchises were not the typical way of doing business there. In early days, franchisers in China often operated substandard businesses, and some may have defrauded franchisees of money. At the same time, franchisees delayed payments to franchisers, and a few infringed on their intellectual property rights. In 1997, the Ministry of Internal Trade established the first Chinese franchise law, leading to a dramatic rise in franchising. By the end of 2010, there were more than 4,500 different franchisers and over 400,000 franchise stores in China, covering 70 industries.
KFC was one of earliest foreign entries and has become the most successful Western fast-food chain in China since it first came to Beijing in 1987. Today there are over 3,300 KFC restaurants in more than 700 cities, with a new KFC opening nearly every day. As a franchiser, KFC sources food from local suppliers and has changed its menu to suit Chinese tastes. In China’s KFCs, you can order a typical Kentucky Fried Chicken meal as well as Sichuan spicy sauce and rice, egg soup, or a “dragon twister” (KFC’s take on a traditional Beijing duck wrap), all washed down with some soybean milk. The parent company of KFC, Yum! Inc., also introduced Pizza Hut and Taco Bell and its combined 3,900 Chinese franchises earned more revenue than all 19,000 Yum! Brand restaurants in the United States. In April 2011, Yum! made an offer to acquire virtually all the shares of Little Sheep, a very successful domestic hotpot restaurant chain of China, with the intention to further expand its franchise chain in China.
Numerous Chinese restaurants have also found franchising to be a profitable way to expand.A good example is Quanjude, a 147-year-
old restaurant famous for its Peking Roast Duck that it has served to many of the world’s leading politicians and celebrities. After decades of success under the planned economy, Quanjude started to face fierce competition from both domestic and foreign restaurant brands. In order to expand business and popularize the brand name, it launched a major program of expansion in 1993. Quanjude opened company-owned restaurants in major cities like Beijing and Shanghai, where it could better monitor store operations. In smaller cities, Quanjude relies more on franchisees, who are more familiar with the local market. By scaling, modernizing, and franchising, this century-old company had a boom in business and successfully went public in November 2007. But franchising has not gone smoothly; the company’s profits still mostly come from company-owned restaurants in the Beijing area.
Over recent years, franchises in other industries are emerging, with service franchises experiencing the sharpest growth. Dongfangaiyin first introduced the concept of early childhood education into China in 1999 and now has 400 franchise education centers in more than 180 cities. Franchising is especially valuable in this industry due to the highly diversified needs across the Chinese population in different areas. At the same time, foreign leading brands in early childhood education such as Gymboree from the United States and KindyROO from Australia have entered the Chinese market with hundreds of franchises of their own. These companies provide training programs to ensure that the standards of teaching and service quality are in sync with those of the parent company. With advanced education concepts and Western-style education, they are usually more popular in bigger cities. With a burgeoning middle class in midsize and small cities, the early education franchising market is likely to see further growth.
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of oil in the open market. This forces their internal production divisions to stay competitive with independent oil producers.
If tapered integration offers the best of both the make-and-buy worlds, it may also offer the worst. Forced to share production, both the internal and external channels might not achieve sufficient scale to produce efficiently. Shared production may lead to coordination problems if the two production units must agree on product specifications and delivery times. Moreover, a firm’s monitoring problems may be exacerbated. For example, the firm may mistakenly establish the performance of an inefficient internal supplier as the standard to be met by external suppliers. Finally, managers may maintain inefficient internal capacity rather than close facilities that had formerly been critical to the firm. An example of this approach is the excess capacity for internal productions maintained by major movie studios.
Franchising
Many of the world’s best known companies are franchise operations. A typical franchiser, such as McDonald’s restaurants and SPAR convenience stores, starts out as a local business. If the business thrives, the owner may wish to expand to new markets. Rather than borrow money and open new stores themselves, the franchiser (e.g., McDonald’s Corporation) gives partial ownership rights to franchisees (e.g., owners of local McDonald’s restaurants). Franchising allows small-business owners such as Ray Kroc (McDonald’s) and Adriaan van Well (SPAR) to grow rapidly. Franchisees put up the capital to build and operate their stores and pay a fee for the right to use the franchiser’s name and business model. Franchisers may also require franchisees to purchase from designated suppliers, offer specific products, and conform to architectural and design guidelines.
The economics of vertical integration helps explain the attractiveness of franchising. The franchiser performs tasks that involve substantial scale economies, such as purchasing and branding. Franchisees keep their residual profits, giving them strong incentives to make investments to serve their local markets, such as identifying good locations and tailoring product selections to local tastes. By allocating decision rights in these ways, there is little lost and much gained by dispersing ownership of individual franchises. Franchisers do sometimes face free-riding problems as retailers benefit from the corporate brand reputation. For example, a McDonald’s franchise owner can expect a certain amount of business based on brand name alone and may be tempted to cut corners on quality. This would reflect badly on other McDonald’s locations, however, and explains why franchisers often maintain tight quality control through frequent surprise inspections, and by dictating certain aspects of production, including choice of suppliers and employee uniforms.
Strategic Alliances and Joint Ventures
Since the 1970s, firms have increasingly turned to strategic alliances as a way to organize complex business transactions collectively without sacrificing autonomy. Alliances may be horizontal, involving collaboration between two firms in the same industry, as when Sina (China’s main Internet portal) and Yahoo partnered to offer auction services in China. They may be vertical, such as when Moroccan tile manufacturer Le Mosaiste teamed up with Los Angeles interior designer Vinh Diep to create computer-aided design renderings of Le Mosaiste’s mosaic tiles in “real-world” living spaces. Or they may involve firms that are neither in the same industry nor
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EXAMPLE 4.5 TOYS “R” US ENTERS JAPAN
In the 1980s, Toys “R” Us, the leading toy retailer in the United States, was eager to enter the Japanese market. Japan’s Large-Scale Retail Store Law required that Toys “R” Us be approved by Japan’s Ministry of International Trade and Industry (MITI) before building its stores. This law, which protected Japan’s politically powerful small merchants, made it difficult even for Japanese retailers, such as supermarket operator Daiei, to open large-scale establishments. Toys “R” Us concluded that it had to find a local partner. It chose a partner that already had considerable experience bringing an iconic American retailing brand name to Japan: McDonald’s.
Toys “R” Us formed an alliance with McDonald’s-Japan to help it navigate the politically charged entry process. McDonald’s-Japan’s president, Den Fujita, was politically well connected and understood the ordeal Toys “R” Us faced, having built McDonald’s-Japan into the largest fast-food operator in the country. He also had a remarkable knowledge of Japanese real estate. “If you name a city,” he bragged, “I can see the post office, train station, everything.” In 1990, Toys “R” Us and McDonald’s-Japan formed an alliance in which McDonald’s took a 20 percent stake in the Toys “R” Us Japanese unit, Toys “R” Us Japan. As part of the alliance, 9 of the 11 Toys “R” Us stores would have a McDonald’s restaurant on the premises.
This transaction was a good candidate for an alliance both because it pertained to a small and specific element of both companies’ overall business and because it had elements that strongly argued for both “buying” and “making.” Toys “R” Us needed to obtain McDonald’s political know-how, site selection expertise, and business connections to enter the Japanese
market. It would have been extremely costly, perhaps even impossible, for Toys “R” Us to have developed this know-how on its own. These considerations argued for Toys “R” Us “buying” the political and site selection services from the market rather than “making” them itself.
By taking a stake in the success of Toy’s “R” Us’s Japanese venture—through both its 20 percent ownership of the venture and the colocation of the Toys “R” Us stores and McDonald’s restaurants—McDonald’s faced hard-edged incentives to carry out its part of the bargain. For example, McDonald’s-Japan estimated that a McDonald’s restaurant located inside a Toys “R” Us store would generate three times more customers than a stand-alone restaurant would. The potential payoff from this venture gave McDonald’s-Japan a strong incentive to work hard on behalf of Toys “R” Us. The alliance enabled Toys “R” Us to obtain the political services and site selection know-how it needed without having to make costly investments of its own. The alliance also avoided the difficult incentive problems that might have arisen had Toys “R” Us relied on traditional market contracting to obtain the services and know-how it needed.
Today, there are about 170 Toys “R” Us and Babies “R” Us stores situated on all three major islands of Japan, as well as two distribution centers. McDonald’s also remains strong in Japan, although it recently closed over 400 poorly performing stores (leaving over 3,000 still in operation). But the McDonald’s/ Toys “R” Us affiliation came to an end in 2008 when McDonald’s sold its stake in the joint venture to Toys “R” Us following a legal dispute over business consulting services that McDonald’s was supposed to provide to Toys “R” Us.
related through the vertical chain, as when Toys “R” Us and McDonald’s of Japan allied to build Toys “R” Us stores in Japan that would include a McDonald’s restaurant (see Example 4.5).
A joint venture is a particular type of strategic alliance in which two or more firms create, and jointly own, a new independent organization. The new organization may be staffed and operated by employees of one or more parent firms, or it may be staffed
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independently of either. Examples of joint ventures include Sony and Samsung’s S-LCD, which manufactures LCD panels for televisions; NEC Lenovo Japan Group, which develops low-cost PCs for the Japanese market; and Cemex and Ready Mix, which share cement production and distribution.
Alliances and joint ventures fall somewhere between arm’s-length market transactions and full vertical integration. As in arm’s-length market transactions, the parties to the alliance remain independent. However, an alliance typically involves more cooperation, coordination, and information sharing than would occur in an arm’s- length transaction. Kenichi Ohmae has likened a strategic alliance to a marriage: “There may be no formal contract. . . . There are few, if any, rigidly binding provisions. It is a loose, evolving kind of relationship.”10 Like a marriage, the participants in an alliance rely on norms of trust and reciprocity rather than on contracts to govern their relationship, and they resolve disputes through negotiation rather than through litigation.
What kinds of business transactions should be organized through alliances? The most natural candidates for alliances are transactions for which, using the framework in Chapter 3, there are compelling reasons to both make and buy. Specifically, transactions that are natural candidates for alliances have all or most of the following features:
1.The transaction involves impediments to comprehensive contracting. For example, the transacting parties know that as their relationship unfolds, they will need to perform a complex set of activities. But because of uncertainty and the parties’ bounded rationality, the parties cannot write a contract that specifies how decisions about these activities are supposed to be made.
2.The transaction is complex, not routine. Standard commercial and contract law could not easily “fill the gaps” of incomplete contracts.
3.The transaction involves the creation of relationship-specific assets by both parties in the relationship, and each party to the transaction could hold up the other.
4.It is excessively costly for one party to develop all of the necessary expertise to carry out all of the activities itself. This might be due to indivisibilities or the presence of an experience curve.
5.The market opportunity that creates the need for the transaction is either transitory, or it is uncertain that it will continue on an ongoing basis. This makes it impractical for the independent parties to merge or even commit themselves to a long-term contract.
6.The transaction or market opportunity occurs in a contracting or regulatory environment with unique features that require a local partner who has access to relationships in that environment. For example, the strong role that the Chinese government plays in regulating foreign investment requires that nearly all foreign ventures in China are joint ventures with Chinese partners.
Although alliances can combine the best features of making and buying, they can also suffer from the drawbacks of both making and buying. For example, just as traditional market transactions involve a risk of leaking private information, independent firms that collaborate through alliances also risk losing control over proprietary information. The risk of information leakage can often be more severe in an alliance than in a traditional market transaction because the conditions that tend to make an alliance desirable (complex, ambiguous transactions that do not lend themselves to comprehensive contracting) often force the parties to exchange a considerable amount of closely held information.