Evaluation of Firm versus Market - Essay Example

? Evaluation of Firm versus Market According to Besanko et al , transaction cost economics (TCE) focuses on the adverse consequences of opportunistic behaviour as well as the costs of trying to prevent it. Opportunistic behaviour arises when one of the parties to a contract seeks to gain at the expense of the other party by exploiting incomplete contracts. Even though contract law might help to reduce this kind of opportunistic behaviour that can arise because of incomplete contracts, it is highly unlikely that such kinds of behaviour can ever be eliminated for a variety of reasons including the time it would take to think about all the possible eventualities that might result in breaches of a specific contract. Besanko et al (2010) also points out that it is inevitable that incomplete contracting will result in some transaction costs which will influence make or buy decisions. Three key characteristics of TCE are relationship-specific assets, quasi-rent and holdup problems. These key characteristics must be considered in a make or buy decisions. Though it may appear more economically feasible to allow market firms to provide certain input activities TCE may determine otherwise. Vertical Boundaries and the Coordination of Activities According to Besanko et al (2010), a firm’s vertical boundaries refer to the set of activities that a firm performs and those that it depends on market specialty firms to produce for it. A make or buy decision relates to the firm’s decision to perform an activity itself or to purchase the goods relating to that activity from an independent firm. A firm that acquires a supplier that is involved in producing inputs for the firm’s products is now making the input since it is performing the activity internally. Firms’ may choose to integrate backwards or forward. A firm’s decision to make or buy depends on which is more beneficial to the firm. If the firm chooses to make then it will have to engage in vertical integration where it starts or acquires a business in order to facilitate upstream activities that are required for the production of the goods and services that it provides. In making this decision there are various factors for consideration, including the coordination of production flows through the vertical chain. In order to determine whether to make or buy a firm should compare the benefits and costs of using the market as opposed to performing the activity internally. The benefits of using the market include: The fact that firms that are producing for the market (market firms)can achieve economies of scale that cannot be achieved by producing that the firm may not be able to achieve by producing it internally Market firms must operate both efficient and innovative to survive and so they have to subject themselves to the discipline that the market requires. The overall success of the corporate entity may hide the inefficiencies that exist in carrying out specific activities internally. The costs of using the market include: The fact that coordination of production flows through the vertical chain may be compromised when an activity is purchased from an independent market firm rather than performed internally. The risk of private information being leaked to competitors by the independent market firm. transaction costs involved in doing business with independent market firms can be avoided if the activity is performed internally Coordination of production of production flows through the vertical chain is of extreme importance to business. When the decision to buy a product from a market firm is taken coordination of production flows has to be emphasized through the preparation of contracts. In order for this to be a success the decisions that one firm makes must be coordinated with those of the other firm. There has to be a good fit if this cooperative effort is to succeed. The dimensions of production that this encompass are timing fit; size fit; colour fit; and sequence fit. Timing fit relates to the coordination of the increased supply of a new Mercedes Benz with the increased production of the specific input that differentiates that Mercedes Benz from all others. Size fit relates to the fact that the doors of the Mercedes Benz must fit exactly into the space that is made for it. Colour fit relates to the fact that the colour of the doors must match with the colour of the other parts of the Mercedes Benz. That is, if the colour is red then the shade of red that is used for the doors must also be used for the other body parts of the Mercedes Benz. Sequence fit indicates that the proper sequence of activities must be employed in carrying out an activity or a set of activities. Bottlenecks will arise in production if coordination is poor. Not delivering the door of the Mercedes Benz on time will mean that production will have to stop until the Mercedes arise both as a result of the timing fit and the sequence fit. The production of the Mercedes Benz is carried out on a production line. The production moves from adding one specific part to another. If the door does not come on time then this will affect the sequencing of the operation. Furthermore, if the company has only one production line then this will result in a complete shut down of operations until the door is received. Firms cannot allow this to happen and so the contracts will have to include penalties that may arise if timing and sequence is affected by delays. This would include costs to be incurred by the trading partner for reneging on their responsibilities. In the same way, if the size does not fit, Mercedes may have to use its own resources to make adjustments to ensure that there is size fit. This is a very costly exercise that will also result in delays in the production and delivery of the products to distributors downstream. This means that events that take place upstream can impact the business negatively by affecting downstream activities and therefore the firm’s bottom line. Further, if the colour of the door does not fit then costs would be incurred in repainting it to fit with the rest of the automobile. This is an additional transaction cost that the market firm may not want to take responsibility for. It therefore means that personnel from the firms involved will have to be actively engaged in the process of working together and coordinating activities in an efficient and effective manner to ensure that not only the timing, colour, size and sequence fits but also the quality in order to ensure satisfaction which will definitely have an impact on the firm’s downstream activities. In order to ensure dependability, the firm may have to rely on having a representative at all of its trading partners or relying on merchant coordinators, which are independent firms that specialize in the linking of suppliers, manufacturers and retailers (Besanko et al). It may be very difficult to bind these firms to a contract that will allow for compensation if anything goes wrong. Milgrom and Roberts (qtd. in Besanko et al, p. 135) indicates that coordination is especially important in processes with design attributes. Design attributes are processes which should precisely relate to each other. If they do not then a significant amount of the economic value of the Mercedes Benz would be lost because customers buy goods because of the attributes that they possess. If the Mercedes Benz does not have the required attributes that customers have come to expect then they will not demand the product and those who end up buying it will not be satisfied and will therefore look somewhere else for a replacement the next time around. Contracts are by their nature incomplete and so firms cannot depend on them to ensure that design activities are adequately coordinated. If an upstream supplier does not take the necessary steps to ensure that there is proper fit and downstream seeks compensation through court action, the full economic damage may never be recovered as it involves lost customers, the inability for Mercedes to meet deadlines given to its distributors, who may in turn want compensation for lost business deals. With all these costly possibilities, the downstream firm may find the decision to “make”, a less costly and time consuming endeavour. The obvious choice would therefore be to vertically integrate activities rather that going to the market to buy activities. According to Keat and Young (2005), a company may be faced with deciding whether to make significant investment expenditure to produce components or to forgo such investment and contract for the component with a vendor. In consideration of whether to make or buy, however, the firm needs to consider if there are existing suppliers that can gain economies that cannot be gained internally and whether the market firm possess capabilities to execute the process more efficiently. If that is so then the firm should consider whether there are significant relationship-specific assets involved, whether there are any coordination problems or problems with leakage of private information. If these are negative then the firm could consider buying the activities. The firm should also look at the feasibility of detailed contracting. If it is feasible then the firm should buy. It is very natural that there will be other problems which are associated with motivation (agency costs) and lobbying for resources (influence costs). However, these can be managed better than all the problems associated with the decision to “buy” activities. References Besanko, D., Dranove, D., Shanley, M and Schaefer, S. (2010) Economics of Strategy. 5th ed. USA: John Wiley & Sons Keat, P.G. and Young, P.K. (2005) Managerial Economics: Economic Tools for Today’s Decision Makers. 5th ed. New Jersey: Pearson Prentice Hall Read More