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and in-house management may not be sustainable, however. As economies develop, wages increase. So does the supply of skilled managers available to smaller, independent firms. As the giant business groups lose these advantages, they will succumb to the disadvantages inherent in their organizational structures. Tata has doubled in size over the past two decades, but this expansion has occurred largely through acquisitions, while profits have risen by only a third and Tata’s core businesses in steel and telecommunications are struggling.

Chapters 9 and 11 describe how firms can position themselves to outperform their rivals and show why it is difficult for firms to sustain success in the long run. Many of these lessons apply to nations—armed with talented workers willing to work for low wages, we should expect emerging economies in India, China, and elsewhere to enjoy considerable success. It is not clear why this success is often inextricably tied to a handful of diversified multinational business groups. What is clear is that if the advantage conferred by low wages slowly erodes and that advantage is all that these groups possess, then their business models and firm structures will not long endure.

An alternative to this critical perspective on business groups is that the large but low-income consumer markets in countries such as China and India provide large groups with opportunities to innovate and satisfy consumer needs at much lower price levels than are found in Western economies. The intuition is that if a viable product is developed, even at a very low price point, it may be economically feasible because of the large size of the domestic market in India or China and the unwillingness or inability of Western firms to compete in the low-price segment. Moreover, the skills the firm develops in commercializing such products under such constraints will make them more cost competitive against Western firms in their home markets. This innovative side of business groups was first apparent in the aftermath of the Y2K crisis and the rise of such Indian firms as Infosys. It is an important motivation for recent trends toward the offshoring of employees by Western technology firms, who see the need to site their innovation facilities in close proximity to their critical production facilities. For Tata, this can be seen in the Nano Project, in which Tata developed a car that retailed for $2,500 and that had more in common with a scooter than with traditional automobiles. If one only sees groups as pursuing labor cost advantages and neglects this emphasis on innovation, it is hard to understand how Tata could be ranked among the world’s most innovative companies by Business Week in 2008.

CHAPTER SUMMARY

According to the Property Rights Theory (PRT) of the firm, the resolution of the integration decision determines the ownership and control of assets. If contracts were complete, asset ownership would not matter. Because of contractual incompleteness, integration changes the pattern of asset ownership and control, and thus alters the bargaining power between parties in a vertical relationship.

PRT establishes that vertical integration is desirable when one firm’s investment in relationship-specific assets has a significantly greater impact on the value chain than does the other firm’s investment.

Integration does not eliminate self-interest. The governance process within an integrated firm must work to ensure that employees work in the interests of the firm. In this way the governance process can improve coordination and avoid holdup.

Questions • 159

PRT suggests that governance of an activity should fall to managers whose decisions have the greatest impact on the performance of that activity.

The advantages and disadvantages of relying on the market versus relying on internal organization can be expressed in terms of a trade-off between technical efficiency and agency efficiency. Technical efficiency occurs if the firm is using least-cost production techniques. Agency efficiency refers to the extent to which the firm’s production and/or administrative costs are raised by the transactions and coordination costs of arm’s-length market exchanges or the agency and influence costs of internal organization.

Vertical integration is preferred to arm’s-length market exchange when it is less costly to organize activities internally than it is to organize them through arm’s- length market exchange. This cost difference will reflect differences in both technical efficiency and agency efficiency across the two modes of organization.

Vertical integration is relatively more attractive (a) when the ability of outside market specialists relative to the firm itself to achieve scale or scope economies is limited; (b) the larger the scale of the firm’s product market activities; and (c) the greater the extent to which the assets involved in production are relationshipspecific.

Vertical integration and arm’s-length market exchange are not the only ways to organize transactions. A firm may pursue tapered integration, in which it supplies part of its input requirement itself and relies on market exchanges for the remainder.

Firms may franchise when it is important for managers to have local market knowledge.

Firms may undertake strategic alliances or joint ventures. Although the transacting parties remain legally separate under these modes of organization, they typically entail much closer cooperation and coordination than an arm’s-length exchange between two independent firms.

Implicit contracts can substitute for formal vertical relationships.

Long-term, arm’s-length market relationships can provide strong incentives for cooperative behavior and can thus achieve the advantages of vertical integration (e.g., avoidance of transactions costs, flexibility in governance) without incurring the disadvantages (e.g., softening incentives for innovation). The Japanese keiretsu and Korean chaebol provide examples of long-lasting business relationships.

Business groups in developing nations thrive by relying on strong central governance, access to local labor markets, and unique opportunities to innovate.

QUESTIONS

1.What is the Property Rights Theory of the firm? Is this theory consistent with the theories of vertical integration described in Chapter 3?

2.Use Property Rights Theory to explain why stockbrokers are permitted to keep their client lists (i.e., continue to contact and do business with clients) if they are dismissed from their jobs and find employment at another brokerage house.

3.“Integrated firms are more efficient than independent firms if the central office is more efficient than the courts.” Explain this statement. To what extent do you agree?

160 • Chapter 4 • Integration and Its Alternatives

4.How is your ownership of Economics of Strategy path dependent? To what extent does this path dependency provide you with a unique opportunity to exploit what you learn from this book?

5.Why is the “technical efficiency” line in Figure 4.1 above the x-axis? Why does the “agency efficiency” line cross the x-axis?

6.How might globalization and advances in information technology affect the trade-offs between technical and agency efficiency?

7.Is the following statement correct? “Double marginalization helps firms because it enables them to raise prices.”

8.Analysts often array strategic alliances and joint ventures on a continuum that begins with “using the market” and ends with “full integration.” Do you agree that these fall along a natural continuum?

9.How are franchising and tapered integration similar? How do these strategies differ?

10. Most people rely on implicit contracts in their everyday lives. Can you give some examples? What alternatives did you have to achieve the desired outcome?

11. Suppose you observed a hostile takeover and learned that the aftermath of the deal included plant closings, layoffs, and reduced compensation for some remaining workers in the acquired firm. What would you need to know about this acquisition to determine whether it would be best characterized by value creation or value redistribution?

12. What do the keiretsu and chaebol systems have in common with traditional strategic alliances and joint ventures? What are some of the differences?

13. How are business groups like Tata similar to traditional diversified firms like General Electric? How are they different?

14. The following is an excerpt from an actual strategic plan (the company and product name have been changed to protect the innocent):

Acme’s primary raw material is pvc sheet that is produced by three major vendors within the United States. Acme, a small consumer products manufacturer, is consolidating down to a single vendor. Continued growth by this vendor assures Acme that it will be able to meet its needs in the future.

Assume that Acme’s chosen vendor will grow as forecast. Offer a scenario to Acme management that might convince them that they should rethink their decision to rely on a single vendor. What do you recommend Acme do to minimize the risk(s) that you have identified? Are there any drawbacks to your recommendation?

ENDNOTES

1Grossman, S., and O. Hart, “The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration,” Journal of Political Economy, 94, 1986, pp. 619–719; Hart, O., and J. Moore, “Property Rights and the Nature of the Firm,” Journal of Political Economy, 98, 1990, pp. 1119–1158.

2See Masten, S., J. W. Meehan, and E. A. Snyder, “Vertical Integration in the U.S. Auto Industry: A Note on the Influence of Transactions Specific Assets,” Journal of Economic Behavior and Organization, 12, 1989, pp. 265–273.

Endnotes • 161

3See Williamson, O., “Strategizing, Economizing and Economic Organization,” Strategic Management Journal, 12, Winter 1991, pp. 75–94, for a complete explanation of this concept along with a brief discussion of its intellectual history.

4This figure has been adapted from Oliver Williamson’s discussion of vertical integration in The Economic Institutions of Capitalism, New York, Free Press, 1985, Chapter 4.

5Monteverde, K., and D. Teece, “Supplier Switching Costs and Vertical Integration in the Automobile Industry,” Bell Journal of Economics, 13, Spring 1982, pp. 206–213.

6Masten, S., “The Organization of Production: Evidence from the Aerospace Industry,” Journal of Law and Economics, 27, October 1984, pp. 403–417.

7Joskow, P., “Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric Generating Plants,” Journal of Law, Economics, and Organization, 33, Fall 1985,

pp. 32–80.

8Anderson, E., and D. C. Schmittlein, “Integration of the Sales Force: An Empirical Examination,” RAND Journal of Economics, 15, Autumn 1984, pp. 385–395.

9Novak, S., and S. Stern, “How Does Outsourcing Affect Performance Dynamics? Evidence from the Automobile Industry,” Management Science, 12, December 2008, pp. 1963–1979.

10Ohmae, K., “The Global Logic of Strategic Alliances,” Harvard Business Review, March– April 1989, pp. 143–154.

11The idea that future flows provide firms with incentives to maintain ongoing relationships was initially developed by Benjamin Klein and Keith Leffler in the article, “The Role of Market Forces in Assuring Contractual Performance,” Journal of Political Economy, 89, 1981, pp. 615–641.

12If the discount rate is i, then an infinite-lived stream of X dollars per year is worth X/i in today’s dollars. See the Economics Primer for a fuller discussion of present value.

13Palay, T., “Comparative Institutional Economics: The Governance of Rail Freight Contracting,” Journal of Legal Studies, 13, 1984, pp. 265–287.

14Shleifer, A., and L. Summers, “Breach of Trust in Hostile Takeovers,” in Auerbach, A. (ed.),

Corporate Takeovers: Causes and Consequences, Chicago, University of Chicago Press, 1988.

15Owen, W., Autopsy of a Merger, Deerfield, IL, William Owen, 1986.

16Bertrand, M., and S. Mullainathan, “Enjoying the Quiet Life? Corporate Governance and Managerial Preferences,” Journal of Political Economy, 111(5), 2003, pp. 1043–1075.

17This example is based on Uzzi, B., “Social Structure and Competition in Interfirm Networks: The Paradox of Embeddedness,” Administrative Sciences Quarterly, 42, 1997, pp. 35–67.

18Nagaoka, S., A. Takeishi, and Y. Noro, “Determinants of Firm Boundaries: Empirical Analysis of the Japanese Auto Industry from 1984 to 2002,” Journal of the Japanese and International Economies, 22(2), 2008, pp. 187–206.

19Miwa, Y., and J. M. Ramseyer, “The Fable of the Keiretsu,” Journal of Economics and Management Strategy, 11(2), 2002, pp. 169–224.

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PART TWO

MARKET AND

COMPETITIVE ANALYSIS

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