External Contracting
Transcript of External Contracting
-
8/8/2019 External Contracting
1/31
Topic 2
External Contracting
(aka Boundaries of the Firm)
-
8/8/2019 External Contracting
2/31
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
-
8/8/2019 External Contracting
3/31
Defining Firms
Legal definition
Nexus of Contracts
Are you part of MBS? Property Rights approach
-
8/8/2019 External Contracting
4/31
Benefits ofOwnership
If you own an asset what rights does this giveyou?
Residual rights of control Rights to residual returns
-
8/8/2019 External Contracting
5/31
Residual ControlRights
Constraints on your use of the asset
contractual
legal moral
Example: if you own a car, what variablescan you control?
-
8/8/2019 External Contracting
6/31
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
-
8/8/2019 External Contracting
7/31
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
-
8/8/2019 External Contracting
8/31
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?
-
8/8/2019 External Contracting
9/31
ShipperOwnership
Shipper Truck
Trucker
-
8/8/2019 External Contracting
10/31
TruckerOwnership
Shipper Truck
Trucker
-
8/8/2019 External Contracting
11/31
Joint Ownership
Shipper Truck
Trucker
-
8/8/2019 External Contracting
12/31
Third Party Ownership
Shipper
Truck
Trucker
-
8/8/2019 External Contracting
13/31
Efficiency
Does ownership matter for efficiency?
Will any ownership structure lead to too little
care?
-
8/8/2019 External Contracting
14/31
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)
-
8/8/2019 External Contracting
15/31
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)
-
8/8/2019 External Contracting
16/31
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.
-
8/8/2019 External Contracting
17/31
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.
-
8/8/2019 External Contracting
18/31
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
-
8/8/2019 External Contracting
19/31
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?
-
8/8/2019 External Contracting
20/31
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
-
8/8/2019 External Contracting
21/31
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
-
8/8/2019 External Contracting
22/31
Supply Assurance
Supply/MC
Q
$
Normal Demand
As DemandBs Demand
-
8/8/2019 External Contracting
23/31
Supply Assurance
Supply/MC
Q
$
PeakDemand
As Demand
Bs Demand
-
8/8/2019 External Contracting
24/31
Integration
Supply/MC
Q
$
Lossin value
-
8/8/2019 External Contracting
25/31
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
-
8/8/2019 External Contracting
26/31
Case
Nucleon Inc.
-
8/8/2019 External Contracting
27/31
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
-
8/8/2019 External Contracting
28/31
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)
-
8/8/2019 External Contracting
29/31
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
-
8/8/2019 External Contracting
30/31
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.
-
8/8/2019 External Contracting
31/31
Looking Forward
Transactions costs must play an importantrole in firm boundaries
But what are the specific sources of thesecosts?
Contracting difficulties
Incomplete information