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Rajvinder Bhachu 100087804 Outline the theories suggesting the determination of firms boundaries.

Discuss these with reference to at least two examples of firms, either historical or present-day. In this essay, four theories will be discussed, showing how they determine firms boundaries. Firms boundaries will be defined and developed throughout the essay to conclude how these theories effect vertical and horizontal integration. First, Porters Value Chain which identifies firms boundaries and how firms strategies determine different boundaries. Second, Porters Five Force model is discussed, which analyses industries therefore providing the back bone of the whole essay. Third, discussion turns to the theory of economies of scale and scope, determining boundaries through product diversification. Finally, covering transaction cost theory, determining firms boundaries through the scale of transaction cost within the industry. Each theory is illustrated with an example. Boundaries can be horizontal or vertical, horizontal boundaries can be defined by how much a firm produces or sells of one product or range of products. Vertical boundaries can be defined as, the activities which firms control within its supply chain. Firms boundaries can be illustrated by Porters Value Chain analysis, which divides firms activities into primary and support activities. Porter introduces vertical linkages, linking firms value chain with its suppliers value chain (Porter, 2004: 50). Therefore, inefficient supplier production leads to higher purchase costs for firms. Firms may integrate vertically to improve performance at the supplier level. A firms supplier may not be efficiently producing inputs, given the characteristics of the firm; they may intervene and produce inputs to create a cost advantage. For example, The Coca Cola Company owns most of its bottle suppliers around the world (Cimilluca, Mckay and Mccraken, 2010); they vertically integrate, allowing a cost advantage per bottle. If they bought these bottles, it would cost more than if they produced bottles themselves. Thus Coca Colas boundaries are expanded vertically to decrease their production cost, this is how Value Chain analysis can guide the determination of firms boundaries. Porters Five Force model is an analysis of industry rivalry and how it is effected by; threat of new entrants, bargaining power of suppliers and buyers and threat of substitutes. These forces determine industry profitability by indicating the prices charged, cost incurred, and the investment needed to be competitive in that industry (Porter, 1998, p35). An example of new entrant threat is in the soft drinks industry. Producing and supplying soft drinks incurs minimal costs; therefore new entrants can enter. The market leaders in this industry have already created entry barriers such as high sunk costs. Coca Colas brand value is $73 billion according to Brandz.com; which makes it hard for new competitors to compete, with such initial investment preventing entry in to the industry. This shows Coca Cola have had to integrate forward vertically to create a marketing activity which will allow them to achieve brand value. Therefore, positioning in an industry is vital for a firms competitive advantage. Porter suggests two kinds of competitive advantages; lower cost and differentiation. Examples of buyer and supplier bargaining power are in the supermarket and food industry. Tesco have a value range for beans, which they produce and sell, at a lower price than Heinz (Whitwell, 2006). Tesco follows a low cost strategy for their value range and so have different boundaries to that

Rajvinder Bhachu 100087804 of Heinz (Moore, 2008). Tesco exploits buyer bargaining power, because it can purchase raw beans on a large scale, allowing the price per bean to be reduced. Heinz operates a quality differentiation strategy and exploits supplier bargaining power, because it has a unique product, which is demanded by consumers. As this example illustrates, boundaries can be determined by firms trying to achieve different strategies and these strategies are dependent on industry rivalry. Therefore, various industry rivalry impacts firms boundaries in different ways. For Heinz, there vertical boundaries are from inbound logistics to operations, and for the beans value range at Tesco operations are from inbound logistics to marketing and sales. Diversification can occur through economies of scope and scale. Chandler discusses scale and scope economies and how they can be exploited in production and distribution. He defines scale economies as those that result when the increased size of a single operating unit producing or distributing a single product reduces the unit cost of production or distribution (Chandler, 1994, p17). Firms can exploit economies of scale, through buyer bargaining power. In production, firms invest in technology to exploit economies of scale. Firms use this technology to reach their minimum efficient scale, by producing large amounts of throughput within a given period, this lowers average unit cost. Large scale production only occurs through large investment in technology; therefore firms need to control its supply chain to monitor the effectiveness of the technology. This is done through vertical integration. An example, of investment in new technology was in the meat industry that needed to keep meat refrigerated to distribute to consumers. Swift was the first to exploit the refrigerating technology, by distributing meat to the eastern cities of the United States (Chandler, 1974, p25). The technology required the firm to integrate vertically, because they had to monitor the meat in distribution so its quality was not effected, when it reached the end consumer. This meant integrating forward to distributing and marketing, as the refrigerated car needed warehouses to store and Swift developed a marketing organisation in every major city, selling meat through his representatives. This is how economies of scale in production can lead to vertically integrated firms and is one of the ways in which they determine boundaries. Once the investment in technology has exploited economies of scale fully, this is when economies of scale can determine firms boundaries from another angle. To achieve an extra increase in production units were technology meets its minimum efficient scale; firms could integrate horizontally through mergers or acquisitions. Due to a merger, a firm will be able to purchase a larger quantity of inputs at a reduced price per unit. An example of this is the merger of Continental Airlines and United Airlines, increasing output and decreasing cost because the firm can purchase larger quantities of petrol, at a reduced price (Clark, 2010) this is purchase economies of scale. This merger increased the firms boundaries horizontally, because they now sell more of a related product, indicating again how economies of scale determine firms boundaries. Economies of scope can be defined as those resulting from the use of processes within a single operating unit to produce or distribute more than one product (Chandler, 1994, p17). This can be achieved by firms using production activities and distribution channels across all products they produce and sell. This allows exploiting shared activities, such as

Rajvinder Bhachu 100087804 managerial talents and cost sharing. Firms that exploit economies of scope need to do so by integrating vertically and horizontally. Virgin operates a television service, it also offers broadband and telephone services (Orphanides, 2011), resulting in economies of scope. This is because they can produce services using established production techniques, and distribute services using the established distribution channels leading to cost advantages. In this example Virgins horizontal boundaries expand because they produce and sell in more than one industry, and their vertical boundaries expand because they produce, sell, distribute and have an after sales service, therefore suggesting how firms boundaries are determined by economies of scope. Transaction cost is another theory influencing firms boundaries. Transaction cost theory has two main assumptions; bounded rationality and opportunism. Bounded rationality can be described as the limited capacity of human beings to formulate and solve complex problems (Douma and Schreuder, 2008, p163). This leads to managers evaluating the make or buy decision, which is whether the company makes or buys an activity. Firms consider three components; asset specificity, uncertainty and complexity when deciding on purchasing or producing activities (Douma and Schreuder, 2008, p168). Asset specificity is when an asset cannot be used for any other purpose but that within what it was used for originally. Bounded rationality creates problems in environments that are uncertain and complex. This is what leads to the hold up problem. This is a situation where two parties are in a contract, and one gains bargaining power over the other because the asset involved has none or reduced market value. The producer losses bargaining power and the purchasing party can renegotiate the price of the contract. This leads to high transaction costs because of contracting, renegotiation and purchasing. For example, the car manufacturers BMW and Mercedes engage in transactions with component suppliers, these transactions are asset specific. The car manufacturers send over specialist engineers to suppliers to set up a whole production line. In turn the suppliers invest in additional training and working hours for their employees. If the component is not made to the terms set in the contract, the supplier would be left with a component that the original car manufacture would not want and which has no market value, because it is for a specific car (Crouch and Maclean, 2011). This illustrates the hold up problem. The second assumption, opportunism, Williamson defines as self interest seeking with guile and as making self-disbelieved statements. However, Williamson does not assume that everyone behaves opportunistically (Douma and Schreuder, 2008, p164). The small numbers exchange plays a part in opportunism. If there are only a few suppliers in an industry, then this means that a buyer has to pay transaction costs because there is no alternative. However, if there are a large number of suppliers then buyers can choose suppliers who do not behave opportunistically because if they do their reputation is damaged, causing buyers to avoid dealing with the supplier. Therefore opportunistic behaviour depends on the small numbers exchange. There are critiques of opportunism and one will be discussed here, such as the role of trust. In Jewish communities, oral contracts are made for diamond dealings, millions worth of diamonds are passed on because of trust (Douma and Schreuder, 2008, p186). Game theory plays a part in trust, if the firms deal with each other regularly, there are fewer motives for cheating and more

Rajvinder Bhachu 100087804 chance of cooperation, whereas in a one off business transaction, cheating is highly likely (Begg and Ward, 2009). The solution for high transaction cost is vertical integration, depending on industry rivalry, relating to Porters Five Force Model. The example of BMW and Mercedes, illustrates buyer bargaining power. BMW and Mercedes can reduce transaction cost of producing specific component parts, by integrating vertically to produce their own specific components. In doing so, they reduce transaction cost because they do not have to contract, negotiate or purchase the component and can have the component made without the problem of uncertainty or complexity, avoiding the hold up problem. Another example of buyer bargaining power in an industry is if the supplier sells common goods like milk. In the supermarket industry, Tesco have bargaining power over milk suppliers because they are large consumers of the good (Ford, 2011), relating to economies of scale. Therefore in this industry the good is readily available without high transaction cost and the firms do not have an incentive to integrate vertically because, of low asset specificity and low chances of the hold up problem. Therefore transaction cost theory can help determine firms boundaries if the transaction cost of market transacting is high enough, firms can produce the asset in house, resulting in firms boundaries to expand vertically, either upwards or backwards. In conclusion, firms boundaries can be determined by the theories outlined in this essay. Firms boundaries are not identical for firms within the same industry, because different firms have different positions in the industry and therefore exploit their power to take advantage of vertical and horizontal integration. However, other indirect factors can influence firms boundaries, such as law. In the UK, the Competition Commission investigate mergers that are likely to reduce competition within that industry and therefore decrease consumer welfare (Competition Commission, 2012). This suggests that if two large firms in an industry, wanted to merge to exploit economies of scale, this may be investigate and found illegal. Therefore, the law can determine firms boundaries horizontally, which shows that external factors influence firms boundaries. References: Begg, D and Ward, D (2009). Economics for Business. 3rd ed. London: McGraw-Hill Education (UK) Limited. Brandz. (2011). Soft Drinks. Available: http://www.millwardbrown.com/BrandZ/Default/Categories/Soft_Drinks.aspx. Last accessed 20th February 2012. Chandler, A D. (1994). Scale, Scope, and Organizational Capabilities. Scale and Scope: The Dynamics of Industrial Capitalism. Harvard: Harvard University Press. p14-46. Chandler, A D. (1974). Historical Setting. Strategy and Structure: Chapters in the History of the American Industrial Enterprise. Massachusetts: MIT Press. p25-26.

Rajvinder Bhachu 100087804 Competition Commission. (2012). Abouts Us. Available: http://www.competitioncommission.org.uk/about-us. Last accessed 23rd February 2012. Cimilluca, D. Mckay, B. Mccracken, J. (2010). Coke Near Deal for Bottler. Available: http://online.wsj.com/article/SB10001424052748704240004575085871950146304.html. Last accessed 23rd February 2012. Clark, A. (2010). Airline industry United and Continental merge to create world's biggest airline. Available: http://www.guardian.co.uk/business/2010/sep/17/united-continentalmerger-agreement. Last accessed 22nd February 2012. Crouch, C and Maclean, C. (2011). The Responsible Corporation: Regulating the Supply Chain. The Responsible Corporation in a Global Economy. Oxford: Oxford University Press. p125-126. Douma, S and Schreuder, H (2008). Economic Approaches to Organisations. 4th ed. Harlow: Pearson Education . p161-192. Ford, R. (2011). Tesco chops milk prices to counter discounters. Available: http://www.thegrocer.co.uk/fmcg/tesco-chops-milk-prices-to-counterdiscounters/220626.article. Last accessed 22nd February 2012. Moore, M. (2008). Shopping at Tesco in Shanghai. Available: http://blogs.telegraph.co.uk/news/malcolmmoore/4752277/Shopping_at_Tesco_in_Shang hai/. Last accessed 24th February 2012. Orphanides, K. (2011). Virgin Media Broadband Review. Available: http://www.expertreviews.co.uk/software/1280161/virgin-media-broadband. Last accessed 22nd February 2012. Porter, M E. (1998). The Competitive Advantage of Firms in Global Industries. The Competitive Advantage of Nations. 2nd ed. New York: The Free Press. p33-68. Porter, M E. (2004). The Value Chain and Competitive Advantage. Competitive Advantage. First Free Press Export ed. New York: The Free Press. p33-61. Williamson, O E. (1981). The Modern Corporation: Origins, Evolution, Attributes. Journal of Economic Literature. 14 (1), p1537-1568. Whitwell, S. (2006). Stretch Potential: The Supermarket Brands. Available: http://www.intangiblebusiness.com/Brand-Services/Marketing-services/News/Stretchpotential-the-supermarket-brands~390.html. Last accessed 22nd February 2012.

Rajvinder Bhachu 100087804

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