This is “Alternatives to Vertical Integration”, section 5.5 from the book Managerial Economics Principles (v. 1.0).
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If the reduction of risk related to the actions of an independent supplier or buyer is a motivation for vertical integration, the firm may have alternatives to formally integrating into another stage of the value chain through use of a carefully constructed agreement with a supplier or buyer. Done correctly, these agreements can result in some of the gains a business might expect from formal integration of the other stage of value-adding activity.
If the concern is about the reliability of continued exchanges, the supplier firm can establish a long-term agreement to be the exclusive dealer to the buyer firm, or the buyer firm can contract to be the exclusive buyer from the seller firm. In the retail business, these sometimes take the form of franchise outlets, where the franchise enjoys the assurance that their product will not be sold by a competitor within a certain distance and the supplier is assured of having a retailer that features their goods exclusively.
In some cases, the concern may be about future prices. If the upstream firm is concerned that the downstream firm will charge too little and hurt their profitability, the upstream firm can insist on a resale price maintenance clause. If the downstream firm is concerned that the upstream firm will use their exchanges to build up a business and then seek additional business with other downstream clients at lower prices, the downstream firm can ask for a best price policy that guarantees them the lowest price charged to any of the upstream firm’s customers.
Some upstream suppliers may produce a variety of goods and rely on downstream distributors to sell these goods to consumers. However, the downstream firm may find that selling just a portion of the upstream firm’s product line is more lucrative and will not willingly distribute the upstream firm’s entire line of products. If this is a concern to the upstream firm, it can insist on the composition of products a distributor will offer as a condition of being a distributor of any of its products.
One way firms protect themselves from supply shortages is by maintaining sizeable inventories of parts. However, maintaining inventory costs money. Firms that exchange goods in a value chain can reduce the need for large inventories with coordinated schedules like just-in-time systems.The best-selling book by Womack, Jones, and Roos (1990) describes the just-in-time philosophy. In situations where quality of the good is of key concern, and not just the price, the downstream firm can require documentation of quality control processes in the upstream firm.
When upstream firms are concerned that they may not realize a sufficient volume of exchanges over time to justify the investment in fixed assets, the upstream firm can demand a take-or-pay contract that obligates the buyer to either fulfill its intended purchases or compensate the supplier to offset losses that will occur. This type of agreement is particularly important in the case of “specific assets” in economics, where the supplier would have no viable alternative for redeploying the fixed assets to another use.
Although some of these measures may obviate the need for a firm to expand vertically in a value chain, in some circumstances forming the necessary agreements is difficult to accomplish. This is especially the case when one party in a vertical arrangement maintains private information that can be used to its advantage to create a better deal for itself but potentially will be a bad arrangement for the party that does not have that information in advance. As a result, parties that are aware of their limited information about the other party will tend to be more conservative in their agreement terms by assuming pessimistic circumstances and will not be able to reach an agreement. This reaction is called adverse selectionThe tendency of one party to a potential agreement to assume pessimistic circumstances and hold to conservative agreement terms when it is aware that it has limited information about the other party. in economic literature.Nobel laureate George Akerlof (1970) wrote a seminal paper examining adverse selection in the context of used cars.
In some cases, one party in a vertical arrangement may have production or planning secrets that do not affect the agreement per se but risk being discovered by the other party as the result of any exchange transactions. These secrets may be the result of costly research and development but may pass to the other party at essentially no cost, and the other party may take advantage of that easily obtained information. This is a version of what economists call the free rider problem.See the text by Brickley, Smith, and Zimmerman (2001) for more about the free rider problem in economics of organizations. Due to the difficulty of protecting against problems of adverse selection and free riders, firms may conclude that vertical integration is the better option.