1 42001: Competitive Strategy Neale Mahoney Lecture 4: Economies of Scale and Scope
2 The question This module is about integration decisions • Should a firm make both airplane engines and train engines? • Should a firm vertically integrate with an upstream producer or downstream retailer? • Should a firm horizontally integrate with a competitor?
The question 3
4 Coase’s “puzzle”: Why are there firms?
Coase’s observation “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. Those who object to economic planning on the grounds that the problem is solved by price movements …” Ronald Coase, 1937, The Nature of the Firm 5
Coase’s question Why are there firms? • We have all this intuition that “markets work” yet we have these funny things called firms in which many resources are allocated by command-and-control • Why should it even matter whether activities are performed inside a firm or across firms? • Why aren’t we all just independent contractors? – Coase’s “workman” can let Department X and Department Y bid for his services 6
Answers to Coase’s question Transactions Costs • Hiring independent contractor would involve all sorts of transactions costs • Why are transactions costs are lower within firms than across firms? • And why there isn’t a single firm called World, Inc. • If transactions costs are all that matter, shouldn’t GS and Starbucks merge? – Bankers can procure coffee from within the firm rather than across firms? 7
Answers to Coase’s question Incomplete Contracts • If we could write “perfect” contracts then we wouldn’t need firms – “Perfect” = unambiguous in every possible state of the world – Under a perfect contract, there wouldn’t be any distinction between hiring an employee and hiring a contractor – GS could “own” Starbucks (or vice versa) without any real consequences – just include in the merger contract a “leave Starbucks alone” provision • For obvious reasons real-world contracts are imperfect. 8
Answers to Coase’s question Incomplete Contracts • When contracts are imperfect it matters who owns what – “Ownership” = “residual control rights” – Don’t want GS to have residual control rights over any of Starbuck’s assets, or vice versa • No such thing as a perfect “leave Starbucks alone” contract – Any transactions costs benefits of GS and Starbucks merging are dwarfed by how costly it would be to have GS have residual control rights over Starbucks decisions, or vice versa 9
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