Reasons for Vertical Integration of Firms
The Extent To Which Firms Vertically Integrate Is Determined By The Trade-Off Between Technical And Agency Efficiency”. Evaluate This Statement With Reference To The Relevant Theory And Empirical Examples.
Discuss How The Principal- Agent Relation Is Linked To The Issue Of Moral Hazard? Using a Suitable Empirical Context, Assess The Severity Of The Problem And Briefly Suggest Possible Solutions To The Problem/s You Have Identified.
Vertical integration is a term used in management and microeconomics, which refers to the ownership of the supply chain management of a company by that company. Under this system, each member of the supply chain yields a different good or service that is solely market specific. The products are produced as per the needs of the customers. It is important as it determines the growth of the firms, be it backward or forward. The aim of the process is to improve the management and service of the supply chains by lowering the overall production costs. The purpose of the system is to coordinate the activities of the network. Vertical integration works like a retailer who has various brands under its own store and does not stick to the production of their own good (Abate, Francesconi, and Getnet 2014). The integration removes the buying and selling costs that is rendered when separate companies undergo two production stages which raises the cost of a product. It differs from horizontal integration where the firm produces products that can be related to one another.
Vertical integration can bring about a few challenges to the organization and they have to decide things efficiently that will render positive profits. It leads to a trade-off between agency and technical efficiency. Agency efficiency is the extent to which products are exchanged in the vertical integration so as to reduce the agency, coordination and transaction cost (Arcas-Lario, Martín-Ugedo and Mínguez-Vera 2014). Technical efficiency is attained when maximum output is being produced by minimum inputs at a low time. When goods are sourced from other firms then it increases the technical efficiency because it does not need any input for production, however it hampers the supply coordination and therefore leads to a fall in the agency efficiency (Bojnec et al. 2014). The aim of the paper is to understand the extent to which vertical integration is denoted by the trade-off between agency and technical efficiency with respect to relevant theories and empirical examples.
Effects of Vertical Integration
Vertical integration enables the company to operate in the production process of similar firms. Firms undergo vertical integration for a variety of reasons such as deduction in costs, strengthen the supply chains, capture of downstream and upstream profits by accessing new distribution channels. Moreover, vertical integration can be formulated in various ways such as merger, acquisition and internal expansion. Firm get to sell new goods which opens up new channels and leads to an increase in the value of profits. The management of supply chain is strengthened from the reductions in delays and transportation (Sant'Anna et a;. 2017).
The overall costs go down as they do not need to go through various production phases which can fluctuate with respect to input prices. Change is constant in the market and often leads to market failure. Vertically integrated firms remain stable as they do not produce goods on their own and therefore does not affect the cost and revenue badly. Firms operating under the vertical integration system controls the distribution and manufacturing (Andersson and Stone 2017). Since, firms does not produce by themselves, they can sell the product at a much lower cost.
Vertical integration leads to a change in the efficiency of the firms mostly in the areas concerning agency and technical. Technical efficiency is gained from the cost effective production techniques. A firm uses least cost production techniques by using lower inputs, advanced machines that speeds up the production rate, capital and labor intensive techniques as per product requirements (Devicienti, Manello and Vannoni 2017). In vertical internal integration, technical efficiency is attained by selling the goods produced by other firms.
The integration system has huge effects on the agency efficiency where parts of production is outsourced between various brands. If not implemented properly, then the overall effect will fall on the management teams. The system can lead to a logistical nightmare due to coordination problems. The transaction costs are minimized to the lowest level. There is need more organized techniques that can serve the goods effectively and avoid coordination problems. As a result, when the firms increase technical efficiency by sourcing from other firs, it faces a loss in the attainment of agency efficiency (Kashiwagi et al. 2016). Therefore, firms needs to do a trade-off between technical and agency efficacy while determining the level of vertical integration of a firm. Firms needs to find an equilibrium between its efficiency parameters before making an appropriate deal with respect to profit level.
Need for Technical Efficiency
The easiest way to get technical efficiency is by buying the product when the input market of the good is competitive. The price of the inputs becomes similar to minimum average cost. On the contrary, gaining agency efficiency need the firm to make its good because it does not need to render the transaction cost that comes with outside contracting (Abbott and Cohen 2017). Technical efficiency can be gained in various ways. If a firm is able to lower costs by effective skills and advanced technologies, then it tries to purchase the god from other firms and sell them in the market. More the amount of goods to be traded, more there is a arousal o coordination problems which can lower the level of profits.
A firm can benefit from agency efficiency and technical efficiency as per the requirements of the market and the ability of the firm. There are several factors that denotes the factors on which the trade-off between agency and technical efficiency will be efficient which are given as follows:
When the value of economies of scale is comparatively higher, the firm will benefit by buying inputs from other firms rather them producing them. This is because big firms have a high level of production which is due to the spread of the cost over a large amount of goods (Ajayi, Weyman-Jones, and Glass 2017). Larger firms have a lower average cost when they source the input from smaller firms. The negative effect on agency efficiency will be balanced by the technical efficiency.
If the size of the firm is comparatively small it is better to make its own inputs and produce the good. Otherwise production will not be worthwhile as the costs will not go down if they produce in lower amounts. Smaller firms will benefit from agency efficiency and therefore must integrate goods accordingly. This in turn will affect the value of the goods as they can lower the transaction cost by sourcing it to other firms.
Vertical integration is advantageous for the large firms who demands a high amount of input from other firms and gain a larger part of the market share in comparison with smaller firms.
Vertical integration must be made with respect to proper assets and inputs such that there is lack of holdup problems.
If the market for inputs is highly competitive, then it is effective to produce their own good because the prices will be close to lower average cost hat will effectively improve the value of the output with respect
Factors Denoting The Trade-off Between The Two Efficiency Parameters
The willingness of a firm to take its vertical integration decisions depends on the availability of the firms or asset specificity. Large asset specificity firms would experience a greater benefit from integration than the low asset specificity firms. This is because market that lacks asset specificity requires greater supply of goods to fill the gap. Economics of scope and scale enables the superior firms to supply ample products who have a comparative advantage in production (Lambie-Hanson and Lambie-Hanson 2017).
In this case, vertical integration is not the only solution because technical efficiency is attained by using their inputs and factors efficiently. Moreover, there are many alternatives to vertical integration that makes the firm more efficient such as arm’s length market. This market is partially related to vertical integration because buyers are sellers are unknown to each other and are only related by the financial transaction between them.
Figure 1: Agency versus technical efficiency
A firm will choose to integrate vertically provided it means certain criteria which can be explained from Figure 1.
Denotes the change in lowest production cost under vertical integration and minimum production cost under arm’s length market exchange. This value depicts the difference in technical efficiency.
Represents the change in the traction cost under vertical integration and transaction cost organized under arm’s length market. The difference the two values helps in understanding the difference in agency efficiency.
The overall change in the cost between market exchange and vertical integration is understood from which is the vertical summation of and . ‘k’ represents the asset specificity in the horizontal axis. includes several costs such as costs of negotiating contracts and the costs of safeguarding against specific holdups (Baker et al. 2019). Transaction costs comprise of several inefficiencies as a result of under investment in relationship specific assets.
From Figure 1, it is evident that the increase in transaction scale has raised the demand for inputs. This requires the introduction of vertical integration which can better exploit economies of scale and scope in production. The disadvantage of the cost of production with respect to market specialist firm will decline. The value of decreases with a rise in asset specificity. As a result, curve will shift downward. remains positive with respect to low asset specificity which easily facilities the market exchange.
The rise in sale becomes an advantage for the firms with respect to exchange costs. This leads to a clockwise twist of curve through point ‘k*’. According to surveys, firms behave or apSply vertical integration by in accordance to the above principles. Modern firms are solely based on asset specific effects and product market scale. The growth of modern business is based on the strategies of vertical integration which is formulated with respect to economies of scale which shows firms trades off between agency and technical efficiency.
The coal burning electricity generating plants are generally located closer to the coal mines due to the construction site and the specificity of physical asset. Coal burning plants are vertically integrated in a wider basis than the other firms. On the contrary, if the firms does not go for vertical integration, coal suppliers need to depend on the long-term contracts so as to prevent holdup. Firms under the industry of electronic components depends on their own factors rather than other manufacturers (Hunold and Stahl 2016). As a result, vertical integration does not enable technical efficiency and as a result, thee firms are more agency efficient.
The manufacturing industry gather huge profits by buying products from other firms. This is because tools needed for production and manufacturing are different. Some firms have efficient in production and they sell the goods to other firms for processing which enable them the gat huge profits which outweigh the coordination costs.
According to various reports, the aerospace industry has been consistent with the asset specificity. The likelihood of the usage of the vertical integration came from the design specificity. The complex parts of this industry were manufactured internally rather than making them from external providers.
The automobile industry runs efficiently when greater amount of effort and programming application is implemented for operating machines. These make the work faster and helps them to gain a comparative advantage in production. Therefore, car makers include components that needs high amount of engineering applications. The produce tools that needs high knowledge and skill and buy those inputs which require comparatively less skill and effort. Similarly, the market for other technological gods, needs a key skill in that particular area which increase the operating cost (Loertscher and Riordan 2019). Firms operate by integration where manufacturing is done is done by other firms and the processing by others.
The most crucial factor is that culmination of technical and agency efficiency determines the application of vertical integration over arm’s length market contracting. Firms enacting vertical integration generate greater amount of benefits as per technical and agency efficiency. When firms integrate vertically, they gain a control over the asset of other firms which gives them a better bargaining position. Firms are able to negotiate goods more freely as per the needs of the market with respect to various factors that can enhance the functionality of businesses. However, whenever they operate these decisions with other firms, they are unable to take contraction decisions which might capture more value for transaction (Sokol 2018). This boosts the person to make more of the relationship specific investments. This also helps to divide the risk factor as the negative impacts is equally shared by the two firms.
A lower agency efficiency slows down the functioning of the form with respect to various features that enhance the productivity. The implementation of vertical integration is based on the availability of options to buy supplies from other firms which is dependent on the competitiveness of the market. When the competition is huge, firms tend to have alternate options where vertical integration seems as the best option (Abate, Francesconi and Getnet 2014). This is explained from the theory of tampered integration which is vertical integration with respect to market exchange such that the level of risk goes down by integrating when transaction is properly coordinated. However, relying on other firms, might as well increase the risk of delivering and managing the good effectively.
Firms will always face a trade-off between managing technological efficiencies and coordinating them in the proper way out (Zanchettin and Mukherjee 2017). Firms must know about the market structure before undergoing vertical integration because under monopoly there is only a single seller and so vertical integration is not possible. It is effective in perfect competition where there are large number of firms and getting inputs is comparatively cheaper and easier. Although vertical integration is beneficial, firms needs to have a clear knowledge about integration because otherwise the market will be gained by new firms.
Thus, it can be concluded that firms face a trade-off decision between agency efficiency and technical efficiency with respect to vertical integration that may hamper the profitability of the firm. Technological efficiency is attained by vertical integration which lower the overall production cost due to buying goods from other firms and selling them. However, this creates a coordination cost because the delivery of the products from one place to other crates a huge cost which lowers the value of profits and leads to coordination failure. Vertical integration is dependent on the factors of production, economies of scale, competition in the market and structure of the market. Large firms befit from vertical integration because of availability of inputs which lowers the production cost such that it outweighs the coordination costs. Therefore, firms needs to plan their integration efficiently such that they are able to make a tradeoff between agency and technical efficiency which does not lower their profits.
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