Vertical Integrated Firms: Transaction Cost Economies Essay

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Introduction

Some economists have propounded that vertically integrated firms “can try to replicate the market incentives but many do encounter problems associated with agency costs” (Dietrich & Krafft 2012, p. 23). In other words, companies that decide to take charge of their products, as well as the products’ components, cannot market as effectively as those that allow other agencies to control their products’ components. A study through most companies however reveals that vertically integrated companies can replicate market incentives without restriction by agency cost. A good example is technological companies such as Apple. The company has embraced a vertically integrated model with a high degree of success. Apple manufactures and designs hardware and software components of its products without allowing any other company to control any of its components. Pundits have argued that this is the secret to the company’s success over years. This paper will delve into the merits and demerits of vertically integrated models and suggest how they can overcome challenges emanating from agency costs. Salient characteristics of Transaction Cost Economics will be extrapolated vis-à-vis the vertical model.

Main body

Elsner and Hanappi (2008 p. 43) aver that vertical integration “dictates that one company controls the end products as well as its components.” Essentially, the model excludes outsourcing or delegating of products’ components. This means that if one manufactures a mobile phone, he/she must also manufacture all the components that go with the mobile phone. The model stifles specialization and instead encourages a scenario where a company manufactures all components of a product. This inevitably comes with challenges. For instance, the manufacture of complex products requires a set of different skills and competencies. There is also a chain of processes that lead to the manufacture of the particular product. The supply chain process for example has the identification of raw materials, procurement, processing, and manufacturing of the product. It takes a lot of time for a company to build such a capacity. This is because of the intensive labor and skills required. Such a robust undertaking has dissuaded companies from adopting vertical models.

Transaction Cost Economies have some salient features that distinguish them from other economies. These characteristics are important in helping a company make strategic decisions. If a company is deciding on whether to make or buy a component, several factors come into play. TCE operates on the premise that “exchanges between two independent agents involve transaction costs of different degrees” (Dietrich & Krafft 2012, p. 23). A grasp of TCE features is particularly paramount when making such decisions as to whether to make or buy. The first feature is frequency. As the name suggests, frequency is the regularity with which a transaction happens. If a transaction is irregular or rare, it is not worth the allocation of a large number of resources for its operation. On the other hand, a regular transaction deserves adequate resources for coordination. Before deciding to go vertical or otherwise, a company must establish the frequency of a transaction so that it benefits most from the association.

The other feature of TCE is uncertainty. According to Dietrich & Krafft (2012, p.13) uncertainty is “an imperfect knowledge about an event and its outcome”. Based on the definition, it is accurate to state that uncertainty falls into different levels. For a company, sobriquet A, which buys a component from another company, sobriquet B, the question of certainty (or otherwise), is necessitated by “quality, reliability of supply, and timeliness or quality” (Dietrich & Krafft 2012, p. 25). Lack of accurate means to predict the future exacerbates uncertainty especially where long-time transactions are involved. Additionally, company A will be more inclined to ask for a long-term contract so that it is in a position to plan the future.

A long-term contract portends several dangers to the buyer. To start with, the seller may demand re-negotiation of the contract mid-way. On the buyer’s side, there is uncertainty as to whether the seller will maintain quality and timeliness. Unscrupulous sellers renege on agreed terms to push the buyer into opting out and terminating the contract. Uncertainty is perhaps the single most important factor that pushes companies to vertical integration. A company like Apple Company, for instance, is a recognized brand all over the world. If it decides to allow Motorola Company to manufacture some components, for instance, software, it may open itself up to uncertainty. Motorola Company may compromise quality, thus denting Apple’s corporate integrity and ruining its brand essence. The most important question for the buyer is whether opting to ‘make’ rather than ‘buy’ will enhance certainty. As Dietrich & Krafft (2012, p. 9) propounds, the question is “will any savings in transaction costs be enough to outweigh any costs there might be associated with vertical integration?” If the answer is yes, then the vertical solution is the solution. The converse is also true.

Another salient feature of TCE is asset specificity. According to Dietrich & Krafft (2012, p.38), asset specificity is “the transaction in which the investments in the asset would only be valuable from their use of the specific transaction”. In other words, asset specificity seeks to establish the relevance of a particular investment and what cost/benefit will accrue from diverting the resource to another venture. The viability of an investment is determined through cost-benefit analysis. If the cost outweighs the benefits, the venture is not worth undertaking. Conversely, if benefits are greater than the cost, an investment is worthwhile. Asset specificity strength lies in its measurability. Frequency and uncertainty, discussed above, are impossible to quantify accurately. Using asset specificity, Kohleick (2008, p.45) extrapolates that “if transactions involve assets that are only valuable, transaction costs will tend to be reduced in a hierarchy than through vertical integration model”. A company should therefore ponder before adopting the vertical integration model.

Scholars have faulted TCE theory for several reasons. Developed in the middle of the 20th century, the theory has not developed to address the complexities of modern companies. Additionally, technology was not as sophisticated then as it is today. The theory relies on transaction cost and benefits alone, while modern businesses have evolved to complexities erstwhile unprecedented. Psychologists have questioned the veracity of the foundation of TCE that glorifies extrinsic motivation as the primary driver of workers (Glachant, Finon, & Hautecloque 2011, p.11). While the monetary reward is an important consideration for many workers, it does not override other factors such as job satisfaction, flexibility, and proximity to family. In other words, TCE negates the obvious role of intrinsic motivation in enhancing output from workers. Additionally, elucidation of organizations in terms of efficiency is unsatisfactory in fathoming how companies are organized. It fails to take cognizance that human beings have different capabilities.

Vertically integrated companies experience challenges associated with agency costs every time they try to give market incentives. A case in point is electricity supply. Many nations in the world have deregulated electricity supply so that it is affordable to many people. Deregulation involves granting wholesale prices. In the United States, two vertically integrated companies, PECO and PPL, set out to provide market incentives to penetrate new markets. The two companies launched an ambitious program to reward customers who abandon their traditional suppliers. Criticized for being anti-competitive, the practice did not yield the desired results. The two companies incurred heavy losses and contributed to an escalation in electricity prices. The retail agency tasked with distributing electricity by the two companies charged exorbitantly, partly contributing to the loss (Elsner and Hanappi 2008, p.35). Vertically integrated companies must examine the market incentives they offer customers especially when they do so through an agency. The cost may be high and unjustifiable.

The challenges presented by agency costs are avoidable through several means. To start with, vertically integrated companies can use performance contracting (Glachant, Finon, & Hautecloque 2011, p.54). Such contracts will outline the minimum expectations of the company, target share, and other terms and conditions. Where necessary, the agency should bid and explain how they will meet the set targets. It is also instructive that vertically integrated companies conduct thorough market research. A simple tool such as Porter’s Five Forces analysis can save a company a lot of costs. Making decisions from a point of knowledge is very important for any business. An evaluation of net value is important before giving incentives. A proper entry strategy is inevitable to ward off competition from those companies that are not vertically integrated.

Technology companies commonly apply a vertically integrated hierarchy. This is because they want to manufacture products with a consistency that will maintain their brand value. Their activities, in most cases, are under one roof. In the United States, Apple Company has been manufacturing hardware and software for Ipads and I-phones. Rather than allow another company to manufacture some components, Apple manufactures everything for itself. This has some dangers. It stifles specialization and limits innovation because it is linear (Glachant, Finon, & Hautecloque 2011, p. 67). Google inc. is vertically integrated but flexible to allow engineers freedom to be creative and innovative. The advancement in technology has significantly reduced transaction cost for many companies. This lowers agency cost that is associated with market incentive, especially for vertically integrated companies. Though considered boring, vertical integration is now eliciting new interest.

Conclusion

Scholars have often argued that ‘vertically integrated firms can try to replicate the market incentives but many do encounter problems associated with agency costs’. The argument is relatively factual considering that agencies charge a lot of money and vertically integrated companies lack flexibility. With the advent of technology, however, the agency cost will not be a big issue. Companies, for instance, Apple, can transact using online markets such as eBay, thus reducing transaction costs. Technological advancement has therefore revived vertical integration. However, the same cannot be said of some companies especially those that require a wide range of raw materials. A company like Coca-cola uses a variety of raw materials. Even if it decides to open subsidiaries in other countries, it will be difficult for it to market without an agency. For such companies, thorough market research is important before any market incentive. For instance, before penetrating a new market, it is vital to investigate the prices of similar products and their promotional strategies. The objective is to come up with a winning strategy that is economically viable. It will not be sensible to give a market incentive that is unsustainable or would lead to a loss.

References

Dietrich, M & Krafft, J 2012, Handbook on the Economics and Theory of the Firm, Cheltenham, UK, Edward Elgar.

Elsner, W & Hanappi, G 2008, Varieties of capitalism and new institutional deals: regulation, welfare and the new economy, Cheltenham, UK, Edward Elgar.

Glachant, J, Finon, D & Hauteclocque, A 2011, Competition, contracts and electricity markets: a new perspective, Cheltenham, UK, Edward Elgar.

Kohleick, H 2008, Designing outsourcing relations in knowledge intensive business services modularisation and systems integration, Köln, Kölner Wissenschaftsverl.

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