External Contracting

8/8/2019 External Contracting

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Topic 2

External Contracting

(aka Boundaries of the Firm)


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Markets versus Firms

If markets are so efficient, why are therefirms?

Coase: different costs associated with transactingin a firm versus a market

But what are these transactions costs?

And what is a firm anyway?

This is the key issue in the

outsourcing debate


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Defining Firms

Legal definition

Nexus of Contracts

Are you part of MBS? Property Rights approach


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Benefits ofOwnership

If you own an asset what rights does this giveyou?

Residual rights of control Rights to residual returns


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Residual ControlRights

Constraints on your use of the asset

contractual

legal moral

Example: if you own a car, what variablescan you control?


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ResidualReturns

Owner of an asset can exclude others fromusing it

Increases bargaining power (added value)

Others are forced to negotiate with you

Example: outsourcing photocopying services

if own copier, can fire worker

if outsource, can only fire copying firm


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Motivating Example

Good requires a truck (the asset) forproduction

Also, enhancing value are: a shipper, S (who wants to ship goods)

a trucker, T(does this): can take care or no carein maintaining truck;

there are many truckers who can take no care but thisparticular trucker is the only one that can take care


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Effortand Value

Benefit from extended truck life

No Care: trucks value is $50

Care: trucks value is $200

Truckers effort cost of care

Minimal care: cost of $10

High care: cost of $100

Marginal Benefit = $150 > $90 = Marginal Cost

Efficient to take care

What happens under different ownership structures for

the asset?


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ShipperOwnership

Shipper Truck

Trucker


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TruckerOwnership

Shipper Truck

Trucker


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Joint Ownership

Shipper Truck

Trucker


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Third Party Ownership

Shipper

Truck

Trucker


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Efficiency

Does ownership matter for efficiency?

Will any ownership structure lead to too little

care?


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Comparing Added Values

How to Share $100

OwnershipStructure

ShippersAdded Value

(ExpectedSurplus)

TruckersAdded Value

(ExpectedSurplus

3rd PartysAdded Value

(ExpectedSurplus)

ShipperOwnership

$100($70)

$60($30)

$0($0)

Trucker

Ownership

$100

($50)

$100

($50)

$0

($0)Joint

Ownership$100($50)

$100($50)

$0($0)

3rd PartyOwnership

$100($46.67)

$60($6.67)

$100($46.67)


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Thingsto Note

In each case, total value created is $100

This is a maximum: $200 - $100

All that differs is distribution The owner of the asset is essential and hence,

their added value is equal to total value created

Asset owners have higher added value than other

agents But the shipper is essential no matter what (in this

example)


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Coase Theorem

If all relevant variables (i.e., effort) arecontractible, then ownership of an assetonly affects the distribution of value andnot the value realised under each

structure.


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MarketsforOwnership

How much will outside party by willing to pay for theasset? Payoff (with ownership) Payoff (without) = $46.67

How much will trucker be willing to pay for theasset? Payoff (with ownership) Payoff (without) = $50 - $6.67 =

$43.33

How much will shipper be willing to pay for theasset? Payoff (with ownership) Payoff (without) = $70 - $46.67 =

$23.33

Outside party will win any asset auction.


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Misconceptionsabout Firm

Boundaries

Merging to realise scale economies

outsourcing to allow others to realise scaleeconomies

Diversifying to realise scope economies

or spinning off divisions to focus on corecompetencies

Integrating to assure supply


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Realising Scale Economies

A A* A

C*

C

AC

Q

Example: Ford supply of anti-lock brakes

If Ford uses enough brakes (e.g., A), itgains no cost advantage in the market

If Ford only uses A, could it gain byoutsourcing?


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Airservices

Largest companies still use regular airlines

some purchase executive jets for special needs

exploration companies need to transport special

equipment

The Kimberly-Clark paper company

production facilities in a number of small towns inWisconsin

started an air service for its personnel this developed into Midwest Airlines


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Realising Scope Economies

Pharmaceutical industry in Australia

Heavily regulated

Retail end is fragmented and owned by independent

pharmacist

Scope economies of marketing and managementservices (branding etc.)

Examples: Mayne, Sigma, API etc.

Contract these services rather than integrate


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Supply Assurance

Supply/MC

Q

$

Normal Demand

As DemandBs Demand


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Supply Assurance

Supply/MC

Q

$

PeakDemand

As Demand

Bs Demand


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Integration

Supply/MC

Q

$

Lossin value


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Summary

What is a firm? Defined by ownership of assets

Do changes in ownership matter?

No, can always find a contracting option that creates thesame value (efficiency)

Yes, owners can negotiate more surplus (distribution) sothey differ in their private value of ownership

What are poor reasons to contemplate changes in

firm boundaries? I.e., outsourcing or integration Economies of scale and scope

Supply assurance


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Case

Nucleon Inc.


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OptionsforNucleon

Phase I/II Phase III/

Commercialisation

Option 1

In-house (pilot plant)

In-house (large scalefacility)

Option 2 In-house (pilot plant) License outmanufacturing rights

Option 3 Use subcontractor In-house (large scale

facility)

Option 4 Use subcontractor License outmanufacturing rights

Option 5 License out License out


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DoesRoyaltyMakeSense?

Completely in-house:

At r = 30%, get NPV of $11.3m

Contract and then in-house

At r = 30%, get NPV of $13.4m

Licensing ex ante

NPV = $5.3m based on 5%

Licensing ex post

NPV = $2 - $4 m (depending on I/II choice)


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PhaseIIIIn-house

Advantages

Protect proprietary processknow-how developed earlier

Avoid technology transferdifficulties

Accumulate skills andcapabilities that maybevaluable for future Nucleon

product

Disadvantages

Nucleon has no priorexperience with large scale

manufacturing; does it wantto take all these risks withfirst product

Process of building amanufacturing organisation

will divert managementsattention from R&D


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PhaseI/II

If not going to keep Phase III in-house, whatadvantages are there to building a pilot plant?

With sub-contractor still have option to scaleup later on.

With licensing, there is no further option.


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Looking Forward

Transactions costs must play an importantrole in firm boundaries

But what are the specific sources of thesecosts?

Contracting difficulties

Incomplete information

External Contracting

Documents

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