March 27th, 2022 
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CONTEMPORARY STRATEGY ANALYSIS
tenth edition
Robert M. Grant
John Wiley & Sons Ltd., 2019
Chapter 10
Vertical Integration and the Scope of the Firm
- Transaction Costs and the Scope of the Firm
- The Benefits and Costs of Vertical Integration
- Designing Vertical Relationships
Vertical Integration and
the Scope of the Firm
Copyright © 2019 John Wiley & Sons, Inc.
OUTLINE
33
- Business Strategy is concerned with how a firm computes within a particular market
- Corporate Strategy is concerned with where a firm competes, i.e. the scope of its activities
- The dimensions of scope are:
- vertical scope
- geographical scope
- product scope
From Business Strategy to Corporate Strategy: The Scope of the Firm
Copyright © 2019 John Wiley & Sons, Inc.
TRANSACTION COSTS AND THE SCOPE OF THE FIRM
34
Multiple specialist firms vs. integration within a single firm
Specialized firms
Single integrated firm
Vertical scope:
Electric cars
Product scope:
Entertainment
Geographical
scope:
Banking
LG (Battery)
Ford (Final assembly)
Magna (Drivetrain)
S Video games
O Consumer
N electronics
Y Movies
Wells Fargo (US)
Banco Bradesco (Brazil)
Lloyds Banking Group (UK)
T Battery
E
S Drivetrain
L
A Assembly
Nintendo (Video games)
MGM (Movies)
Panasonic (Consumer electronics)
Ford Focus Electric
H US
S UK
B Brazil
C + other countries
TRANSACTION COSTS AND THE SCOPE OF THE FIRM
Expanding Scale and Scope
- scale economies from new technologies
- new management tools
- multidivisional structure
- computers
- international expansion
Restructuring, Refocusing and Downsizing:
- Quest for shareholder value: focus on core competences and core businesses
- Turbulent business environment: inflexibility of large, complex hierarchies
- Digital revolution
Top 100 companies’ share of total employment (%)
The changing scale and scope of large US companies
Consolidation through mergers and acquisitions
Quest for scale and market dominance in both mature and hi-tech sectors
Second Industrial Revolution: Growth of industrial giants assisted by electricity, the telephone, innovations in
management and organization
Railways, canals, and telegraph expand firms geographical reach
TRANSACTION COSTS AND THE SCOPE OF THE FIRM
Copyright © 2019 John Wiley & Sons, Inc.
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Chart1
| 1800 | 1800 | 1800 |
| 1810 | 1810 | 1810 |
| 1820 | 1820 | 1820 |
| 1830 | 1830 | 1830 |
| 1840 | 1840 | 1840 |
| 1850 | 1850 | 1850 |
| 1860 | 1860 | 1860 |
| 1870 | 1870 | 1870 |
| 1880 | 1880 | 1880 |
| 1890 | 1890 | 1890 |
| 1900 | 1900 | 1900 |
| 1910 | 1910 | 1910 |
| 1920 | 1920 | 1920 |
| 1930 | 1930 | 1930 |
| 1940 | 1940 | 1940 |
| 1950 | 1950 | 1950 |
| 1960 | 1960 | 1960 |
| 1970 | 1970 | 1970 |
| 1980 | 1980 | 1980 |
| 1990 | 1990 | 1990 |
| 2000 | 2000 | 2000 |
| 2010 | 2010 | 2010 |
| 2020 | 2020 | 2020 |
Sheet1
| Series 1 | Column1 | Column2 | |
| 1800 | 0.7 | ||
| 1810 | 0.5 | ||
| 1820 | 0.6 | ||
| 1830 | 0.7 | ||
| 1840 | 1 | ||
| 1850 | 1.7 | ||
| 1860 | 1.9 | ||
| 1870 | 2.3 | ||
| 1880 | 2.9 | ||
| 1890 | 3.1 | ||
| 1900 | 4.2 | ||
| 1910 | 4.9 | ||
| 1920 | 6 | ||
| 1930 | 6.7 | ||
| 1940 | 6.8 | ||
| 1950 | 9.6 | ||
| 1960 | 13 | ||
| 1970 | 14.4 | ||
| 1980 | 13.8 | ||
| 1990 | 11.6 | ||
| 2000 | 11.3 | ||
| 2010 | 11.5 | ||
| 2020 | 11.7 |
- Technical economies from integrating processes e.g. iron and steel production
—but doesn’t necessarily require common ownership
- Avoids transactions costs of market contracts in situations where there are:
— small numbers of firms
— transaction-specific investments
— opportunism and strategic misrepresentation
— taxes and regulations on market transactions
- Superior coordination
The Benefits of Vertical Integration
7
Copyright © 2019 John Wiley & Sons, Inc.
THE COSTS AND BENEFITS OF VERTICAL INTEGRATION
39
- Differences in optimal scale of operation between different stages of production prevent balanced vertical integration
- Inhibits development of distinctive capabilities
- Difficulties of managing strategically different businesses
- Incentive problems: lack of “high-powered” incentives
- Limits flexibility– in responding to demand fluctuations
— in responding to changes in technology,
customer preferences, etc.
(But, may be conducive to system-wide flexibility)
- Compounding of risk
The Costs of Vertical Integration
Copyright © 2019 John Wiley & Sons, Inc.
THE COSTS AND BENEFITS OF VERTICAL INTEGRATION
40
How many firms in the adjacent stage?
Do transaction-specific investments necessary?
The greater the need for transaction-specific investments, the greater the advantages of VI
Is information evenly distributed across the stages?
The greater are information asymmetries, the greater the advantages of VI
Is there uncertainty over the period of the relationship?
The greater the uncertainty, the more incomplete is the contract and the greater the advantages of VI
How similar is optimal scale between the two stages?
The greater the dissimilarity, the less advantageous is VI
How strategically similar are the two stages?
Do capabilities in the adjacent stage need to be continually upgraded?
The fewer the number, the less advantageous is VI
Are profit incentives critical to performance?
The greater the need for high-powered incentives the greater the disadvantages of VI
Unpredictable demand reduces advantages of VI
Is market demand uncertain?
The greater the need for capability development the greater the disadvantages of VI
Is the adjacent stage highly risky?
VI tends to compound risk
Characteristics of the vertical relationship
Implications for VI
Vertical Integration v. Outsourcing: Key Considerations
Do transaction-specific investments necessary?
THE COSTS AND BENEFITS OF VERTICAL INTEGRATION
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Iron ore
mining
Steel
production
Steel strip
production
Can
making
MARKET
CONTRACTS
VERTICAL
INTEGRATION
MARKET
CONTRACTS
Canning of
food, drink, oil, etc.
VERTICAL
INTEGRATION,
AND MARKET
CONTRACTS
What factors explain why some stages are vertically integrated,
while others are linked by market transactions?
The Value Chain for Steel Cans
Copyright © 2019 John Wiley & Sons, Inc.
THE COSTS AND BENEFITS OF VERTICAL INTEGRATION
- Choices not limited to vertical integration or arms-length market contracts:
— Several intermediate types of vertical relationship: these may combine benefits of both market transactions and internalization
- Key issues in designing vertical relationships:
— No generic solution: depends upon the resources,
capabilities and strategy of the individual firm
— How is risk to be allocated between the parties?
— Are the incentives appropriate?
Long-Term Contracts and
Quasi-Vertical Integration
Copyright © 2019 John Wiley & Sons, Inc.
DESIGNING VERTICAL RELATIONSHIPS
41
Spot sales/ purchases
Long-term contracts
Agency agreements
Franchises
Vertical integration
Joint ventures
Informal supplier/ customer relationships
Supplier/ customer partnerships
Degree of Commitment
Formalization
Different Types of Vertical Relationship
Low
High
Low
High
Copyright © 2019 John Wiley & Sons, Inc.
DESIGNING VERTICAL RELATIONSHIPS
3
- From competitive contracting to supplier partnerships, e.g. in autos
- From vertical integration to outsourcing (not just components, also IT, distribution, and administrative services).
- Diffusion of franchising
- Technology partnerships (e.g. IBM- Apple; Canon- HP)
- Inter-firm networks
General conclusion:- boundaries between firms and markets are becoming increasingly blurred.
Recent Trends in Vertical Relationships
Copyright © 2019 John Wiley & Sons, Inc.
DESIGNING VERTICAL RELATIONSHIPS
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