ECON 600
Lecture 1.5: Theory of the Firm & Vertical Integration
- The Coase Conjecture
We now arrive at what I call “the Coasean Conjecture” (my term, not used by other economists to my knowledge). This concept has been around for a long time, so it can’t really be attributed to Ronald Coase (1991 Nobel Prize winner in economics). But in my opinion, Coase did more to expand and clarify its use than anyone else.
The Coase Conjecture is this: Private transactions will tend to move assets to their highest-valued uses, regardless of initial ownership. Here are some examples:
- A piece of land currently being used as a farm. Its present value in this use is $1,200,000. But if it were converted to residences, it would generate present value of $1,500,000 (net of the conversion cost). Then the land will eventually be converted to residences, either (a) because the farmer does it himself, or (b) the farmer will sell the land, at a price between $1.2 million and $1.5 million, to someone who will make the conversion.
- Slaves in the Old South. Some slaves were skilled at crafts such as carpentry, so naturally their owners wished to use them for that purpose. The problem is that slaves had little incentive to reveal their true skills. A good carpenter could pretend to be a lousy carpenter, and he had every reason to do so, because he would get nothing in return. So owners of such slaves would offer them additional compensation – wages! – for their work, even though legally they didn’t have to. This kind of private transaction between owner and slave moved an asset – the slaves’ labor – to a higher-valued use. (One difficulty with this approach is that contracts between owners and slaves were not enforced legally; more on this below.)
- Sports stars (draft versus free agency).
- Celebrity dating (studio system versus free agency).
In general, then, we expect the market system to move assets around until they are employed in highest-valued uses. But there is an important caveat. A more accurate version of the Conjecture would be this: “Private transactions will tend to move assets to their highest-valued uses, regardless of initial ownership, so long as transaction costs are sufficiently low.”
Transaction costs are costs that must be expended to make a transaction occur, and which are not experienced as benefits to either party. For example, if I buy a bottle of Coke in a 7-11, the (regular) cost to me is $1.29, and the cost to the store is the bottle of Coke. Neither of these is a transaction cost. What is a transaction cost, however, is the effort of pushing my dollar bills across the counter. To take a less mundane example, if you purchase a house, there can be large transaction costs of writing up the contract or contracts needed to complete the sale. The money paid to an attorney is paid by one or both of the parties to the transaction, and it is gained by neither.
Transaction costs can also result from strategic considerations. We will talk more about these when we get to the game theory section of the course. But the most important strategic source of transaction costs is the cost of bargaining. When two parties are trying to get as large a share of the gains from trade as possible, they can expend a lot of time and energy, and that time and energy does not increase the gains from trade – it only shifts them from one party to another. Notice that the existence of competitive markets can reduce this kind of transaction cost; if I don’t like the price offered by 7-11 for my Coke bottle, I can go elsewhere to buy it. The price of Coke summarizes a great deal of information about the willingness of sellers to sell and buyers to buy, so it’s not necessary to have a time-consuming bargaining process for each and every sale.
Finally, transaction costs can result from ill-defined or ill-enforced property rights. This source of transaction costs is so important that it could be stated as a separate condition of the Coase Conjecture. When the initial allocation of rights is not well defined, parties may spend resources trying to establish ownership, and value-increasing transactions may be more difficult to reach because the parties can’t agree on their starting point. When property rights are not well enforced, some value-increasing transactions that involve an exchange over time may not occur because parties cannot make credible promises to fulfill their commitments. For example, because that contracts between slaves and slave owners could not be enforced (the slave could not take the owner to court for failure to pay), some mutually beneficial transactions between slaves and owners likely did not occur.
II.The Coasean Theory of the Firm
The Coase Conjecture underlies the Coasean Theory of the Firm. If transaction costs were always low in market settings, it would be possible to conduct all economic transactions through markets. Yet much of our economic activity occurs not in markets, but within firms, where the price mechanism is typically inoperative. As Coase put it:
For instance, in economic theory we find that the allocation of factors of production between different uses is determined by the price mechanism. The price of factor A becomes higher in X than in Y. As a result, A moves from Y to X until the difference between the prices in X and Y, except in so far as it compensates for other differential advantages, disappears. Yet in the real world, we find that there are many areas where this does not apply. If a workman moves from department Y to department X, he does not go because of a change in relative prices, but because he is ordered to do so. (Coase, “The Nature of the Firm,” in Putterman p. 91)
So we have two forms of economic organization working simultaneously: deliberate or centralized organization within the firm, and decentralized organization in the market. What determines the boundary between the two? Or, to put it another way, why do we have firms at all?
The answer suggested by Coase is that the transaction costs of buying and selling in the market may large enough to deter some market transactions.
(1) When you buy each factor of production each time it is needed, you have to conclude a series of contracts, with a new contract each time the factor is hired again. It might be less costly to have a single contract that lasts over a period of time.
(2) If the market is not fully competitive, there are not clear market prices. Instead, you have to engage in some amount of bargaining, which can be costly for reasons outlined above.
(3) There may be search costs associated with finding the factors of production on the market, and you can economize on these search costs by arranging not to repeat them too often.
(4) The factors you’ve hired in the past may be more valuable to you than “anonymous” factors you could hire on the market, because of asset specificity. This occurs when the factors you’ve hired in the past have gained certain attributes, such as information, familiarity with routines, familiarity with other factors you’ve hired, physical proximity to other factors you’ve hired, and so on. As a result, there are greater gains from trade than there would be with non-anonymous factors, and thus there is room for potentially costly bargaining. We will expand on the topic of asset specificity later.
These points might lead one to believe that firms should always supersede markets; why not have just one big firm? But there are costs (including transaction costs) associated with organization within the firm as well.
(1) Using the firm means forgoing some of the incentives provided by the market. The competitive process of the market helps assure that you are paying the going price for whatever factors you purchase, instead of paying higher prices locked in by long-term contracts. (But could the contract also lock in low prices? Yes, but then you can sell the factors you own on the market; if you don’t, then the opportunity cost of those factors is still the market price.)
(2) Using the firm also means forgoing some of the information provided by the market. Market prices established by a competitive bidding process indicate where factors are most valuable, whereas within the firm there are usually no prices to indicate which department offers to highest return to a factor. [Consider a consulting firm in which head consultants take on projects and then use the firm’s resources, including other employees, to fulfill project obligations.]
(3) A closely related point is that markets provide agents with powerful incentives to use valuable private (local and/or tacit) information. Much relevant knowledge does not exist in centralized form, but instead is dispersed throughout the economy in the minds of numerous individuals. “Local” information is information possessed by someone at a particular time and place; “tacit” information is information that is difficult to communicate to another person. Local and tacit information is only revealed if the individuals have it also have an incentive to reveal it and act upon it. While markets create powerful incentives for the use of private information (because you can profit directly from the use of your information), it is difficult for contracts to duplicate those incentives.
The point here is that information and incentives problem exist in both the centralized firm setting and the decentralized market setting. The boundary between firm and market depends on the relative weight of the various factors listed above – and other factors that we will discuss in greater depth later in the course. The owners/managers of a firm need to analyze the advantages and disadvantages of centralization at the margin to set the appropriate boundaries for the firm.
III.The Make-or-Buy Decision
The fundamental question that defines the issue of vertical integration (or the lack thereof) is the make-or-buy decision. The more a firm makes its inputs, the more vertically integrated it is; the more it buys its inputs, the less vertically integrated it is.
Make-or-buy is not really an all-or-nothing proposition. There is actually a continuum: from arm’s length market transactions, to long-term contracts, to strategic alliances and joint ventures, to parent/subsidiary relationships, to fully internal activities.
We should also note that a firm’s processes can be divided into two broad groups: the supply chain and the support activities. The supply chain is what we usually think of as the production process: everything from the collection of raw materials to the construction of the product to its distribution to its retailing. We think of the earlier parts of the supply chain as being “upstream” and the later parts as being “downstream,” and it is in this context that the “vertical” in vertical integration seems most apropos. The support activities include accounting, finance, human resources, legal services, marketing, and planning. These activities are not obviously “upstream” or “downstream” relative to the links in the supply chain. But they, too, are subject to the make-or-buy decisions. Some firms outsource their accounting, for example. Once all of these activities and their inputs are considered, it becomes apparent that no firm is completely integrated. (Do any firms besides 3M make their own Post-It notes?)
Some terminology that will ease our discussion: The “subject firm” is the firm that is making the make-or-buy decisions, in other words, the firm we are focusing on. “Market firms” are the firms in the external market that provide goods/services when the subject firm chooses to buy instead of make.
IV.Fallacies/MisleadingArguments for Vertical Integration
The text [Besanko] lists several fallacious, or at least misleading, ideas about why a firm should choose to make instead of buy.
1. A firm should make something if it’s a source of competitive advantage.
Response: What does it mean for something to be a source of competitive advantage? If it’s less expensive to buy the input than to make it in-house, then it’s not really a source of competitive advantage.
2. A firm should buy in order to avoid the cost of making something.
Response: Somebody has to pay the cost of making it. If you buy it, you have to pay the supplier enough to cover their costs of production. The real question is whether they can make it more cheaply than you can.
3. A firm should make in order to avoid paying the profit margin of a market firm.
Response: This argument is not totally fallacious, but it should be treated skeptically. If the market firm is making a profit that seems high, there’s probably a good reason. There could be barriers to entry in that market, which the subject firm might not be able to overcome any better than other potential competitors of the market firm. Or the market firm’s profits could be merely accounting profits, which don’t take into account some implicit costs that the subject firm would have to incur as well if it chose to make instead of buy. Or the market firm may have special advantages, like proprietary technology or privileged access to inputs, that the subject firm cannot duplicate.
4. A firm should make to avoid paying high market prices during periods of high demand or low supply.
Responses: 1. If the market price of the input is currently high, then if the subject firm makes it and chooses to use it instead of selling it, the opportunity cost of using it is still the high market price. In addition, the price may rise because of high costs of production, which the subject firm would incur if it tried to produce the input. 2. If the issue is just that the firm wishes to smooth out variation in profits, the subject firm can use futures (a form of insurance) to hedge the risk. Or it could use the capital needed to start the new division to set up a reserve fund instead. There are plenty of ways to insure against risk without taking over production of an input.
V.Reasons to Buy, Not Make (or, the Costs of Vertical Integration)
Here is a summary of the benefits of using the market (i.e., buying), which of course are also the costs of producing in-house (i.e., making):
1. Market firms can achieve economies of scale; an in-house department producing only for the firm’s needs might not have high enough production to do so. (We will discuss economies of scale in much greater depth in a later lecture. For now, you should know that it means the ability to achieve lower per-unit costs by producing larger quantities during any given period of time.)
Example: External health insurance is usually purchased by small and medium companies, while large companies often self-insure. Large companies have enough employees that the insured population is sufficient for risk-spreading.
But why not produce enough to achieve scale economies and then sell the rest? Even if that happens, somebody ends up buying in the market. Also, the buyers may be the subject firm’s competitors, who may fear hold-up problems.
2. Market firms may have already achieved learning economies that an in-house department would take a long time to achieve. (Again, we will discuss learning economies in greater detail in a future lecture. For now, you should know that learning economies means the achievement of lower per-unit costs as a result of experience or learning-by-doing. Usually we use cumulative output as a proxy for experience.)
Also, since the market firm produces enough for many different buyers, it will tend to achieve high cumulative production sooner (moving down the learning curve more quickly).
3. Market firms may possess proprietary information or technology (e.g., a patent) that allows for lower costs.
4. Market firms must be efficient to survive, whereas an inefficient department may be enabled to survive by the “cover” provided by the firm’s overall success. The inefficient department also faces no competition for the services it provides to the firm.
Example: The in-house copy center. If the center is guaranteed to get all the copy orders from the company, it has no particular reason to cut costs.
5. The principal-agent problem is a bigger difficulty for the larger firm, because it’s more difficult to distinguish the particular gains and losses attributable to any particular person or division. (We will discuss the principal-agent problem in greater depth in a later lecture. For now, you should know that it’s the problem that arises when one person, known as the agent, is hired to act on behalf of another, known as the principal. The agent may not have sufficient incentive to act in the principal’s best interests.)
There may also be a free-rider problem, since everyone benefits from the productive activity of one person, while that one person will bear the costs of his efforts. This creates an incentive not to work as hard.
6. Larger firms may be subject to influence costs. Departments lobby for a greater share of resources allocated by central management. This is costly (a) because of the time and effort spent on such lobbying, and (b) because of the misallocation of resources that may result.