Deck 19: Vertical Integration and Outsourcing

Question 1

What limits the entire economy from being served by one gigantic firm that produces everything?

Answer 1

The answer lies in investment incentives. Vertical integration is helpful only when firms have firm-specific assets. However, there are lots of nonspecific assets, and for these, long-term contracts are better and more efficient. That is why catering, trucking, copying and cleaning are outsourced, as they are not firm-specific.

Question 2

Why aren't all economic transactions conducted through markets?

Answer 2

Market transactions are costly. So sometime nonmarket transactions are better. The reasons are due to the presence of firm-specific assets, costs of measuring quality, externalities, and coordination problems. Assets that are very valuable to the firm but not to any other use are firm-specific assets. Quality is easily observable only after delivery. Free-riding by the distributors is an example of externalities. Coordination between different units regarding production, distribution and pricing are difficult.

Question 3

DrugCo has two demand equations for its retail products (pain reliever and cancer):
Pain relief: P = 100 - 10 Q
Cancer drug: P = 200 - 15 Q
The marginal cost of production is $30. Which product should go to the retail market and which should go to the wholesale market? What are the corresponding retail and wholesale prices? What would happen if the sales are switched from the retail to the wholesale and vice versa?

Answer 3

Start with the pain relief drug: P = 100 - 10 Q So MR = 100 - 20 Q Setting MC = MR we get 30 = 100 - 20 Q or 20 Q = 70 Or Q = 3.5 units and so P = 100 - 10 (3.5) = $65 Now going to the cancer drug: P = 200 - 15 Q So MR = 200 - 30 Q Setting MC = MR we get 30 = 200 - 15 Q Or 15 Q = 170 or Q = 11. 33 units and so P = 200 - 15(11.33) = $30.05 So in the retail markets both drugs will be priced at $65 and $30.05 respectively. The wholesale drug will cost $65 to the wholesalers and the company will retail the cheaper drug to the consumers Switching this order will allow other manufacturers to buy the cheaper drug which can be resold in the wholesale market for a much higher price but less than $30, and drive DrugCo out of business.

Question 4

If a firm purchases a part of its supplies on the open market, this is called:

A) a spot market purchase.
B) a long term contract.
C) vertical integration.
D) downstream integration.

Question 5

Firm specific assets, costs or measuring quality, externalities, and coordination problems all may mitigate against:

A) vertical integration.
B) long term markets.
C) open markets.
D) efficient production methods.

Question 6

When a firm establishes a long-term contract with another firm where a firm acquires an asset such as a machine or a building through a rental agreement, this is a:

A) standard supply contract.
B) joint venture.
C) lease contract.
D) franchise agreement.

Question 7

Tasty Chicken, Inc. has worked hard to develop its brand name. Its motto "Absolutely Tasty" has become a common term used for good food. But the company finds that grocery stores do not feature their products in high visibility areas. Further, restaurants never tell their patrons they are eating "Tasty." What needs to be done?

Question 8

Why are firm-specific assets so important in the decision to build internally, negotiate a long-term contract, or buy on the open market?

Question 9

When a firm establishes a long-term contract with another firm where the first firm grants a second independent business the rights to use the first firm's name, reputation and business format, this is a:

A) standard supply contract.
B) joint venture.
C) lease contract.
D) franchise agreement.

Question 10

While firms buy many of their inputs through the open market, there is often a desire to produce critical inputs. A common concern in producing an input yourself (internally) is that:

A) the firm will find it too easy to manage quality.
B) the firm will not minimize costs at a high enough level of output.
C) outside competitors will learn about your inputs.
D) your firm will get prompt supply of the input.

Question 11

Agri-Tech supplies a patented sweetener to various food processors. It has noticed that the value of the sweetener varies dramatically from one buyer to another, depending on the end-use demand. But its experiments with charging higher prices to some buyers have failed. The demand for the juices is supplies are highly price elastic while the demand for sweetened medicine is relatively less elastic. Can Agri-Tech find a way to successfully price discriminate?

Question 12

Markets are usually preferred by economists for efficient transactions. However, Ronald Coase noted that administrative solutions may be superior because market transactions are:

A) never at the equilibrium price.
B) not costless.
C) always result in a price that clears the market.
D) hindered by technological change.

Question 13

When a firm establishes a long-term contract with another firm that is characterized by common ownership of a supplier with another firm, this is a:

A) standard supply contract.
B) joint venture.
C) lease contract.
D) franchise agreement.

Question 14

What is outsourcing and what forms does it take?

Question 15

Nonmarket transactions refer to:

A) purchase in the a spot market.
B) vertical integration.
C) short term contracts.
D) market power

Question 16

Tasty Chicken, Inc. is a large producer of chicken for grocery stores. It usually engages in a long-term contract with these stores to maintain demand for its product. However, Tasty Chicken is regularly plagued with rising and falling prices for its supplies: particularly chicken feed and new chicks. Should Tasty Chicken vertically integrate upstream, building or buying a hatching company and an animal feed company? What are the pluses and minuses of such a decision?

Question 17

When a corporation participates in more than one successive stage in a multi-stage production process it is said to be:

A) vertically integrated.
B) completely outsourced.
C) engaged in preliminary contracts.
D) functionally organized.

Question 18

AutoCorp faces a demand for its primary line of sporty mini-cars in Little Rock of P = $30,000 - 5 Q with a production cost of MC = $8,000. Discuss the implications of selling the new mini-car through its own dealership or through the local dealer: MiniMart.

Question 19

Autocorp faces the following demand function for its automobiles:
P = 55,000 - 200 Q
Its MC is $9,000. What will its price be if it decides to sell the automobiles by itself and what will the price be if it sells though SUVmart, an independent distributor. What is the consequence of this exclusive dealing on prices?

Question 20

If a firm decides to move away from ownership of a vertically integrated production process and begins to purchase supplies or other services from other businesses, this is known as:

A) downstream integration.
B) upstream integration.
C) vertical integration.
D) outsourcing.

Question 21

The case of the Kodak - IBM outsourcing agreement for payroll software indicates that ________ can cause significant long-term holdup problems.

A) Competitive markets
B) Technological change
C) Specific assets
D) Quality control issues

Question 22

SUVmart wants to buy 250 Rhinos from AutoCorp which wants to charge an upfront franchise fee. What will the franchise fee be?

A) It can be anything below MC so as to guarantee SUVmart's profits.
B) It can be anything above MC so as to guarantee some profits for AutoCorp.
C) It has to be equal to TC so that AutoCorp breaks even on the deal.
D) It has to be equal to MC.

Question 23

A minor, but important reason, for using non-market transactions is that:

A) it avoids sharing proprietary information with other firms.
B) it makes sure there is proper motivation of production efficiency.
C) buying in the market is just too complicated.
D) all input are available is adequate supply in the market.

Question 24

Specific assets can create problems for a company. If a supplier invests in new machinery to deliver a part useful only to its biggest and best customer, it can find itself with:

A) a low cost delivery output.
B) a holdup problem.
C) significant externalities.
D) an outsourcing dilemma.

Question 25

Granting exclusive territories:

A) encourages double markups and free-riding.
B) discourages double markups and free-riding.
C) discourages double markups and encourages free-riding.
D) discourages free-riding but generates double markups.

Question 26

If an important component of a firm's production is difficult to specify in a contract and even more difficult to enforce in its production standards, then it probably makes sense to:

A) buy the component in the open market.
B) use a simple short term contract.
C) vertically integrate upstream to build the component.
D) take the risks necessary to buy the component.

Question 27

Agri-Tech makes machinery for chicken slaughterhouses. Agri-Tech has developed a de-boning technique specifically for Tasty Chicken. It is likely that Agri-Tech will desire:

A) a detailed long-term contract with Tasty Chicken.
B) an open market arrangement with Tasty Chicken.
C) a patent that excludes use by Tasty Chicken.
D) a contract without any price guarantees.

Question 28

The right of residual use of a specific asset by the owner often argues for:

A) buying in the open market.
B) long-term contracts.
C) internal ownership.
D) risk-sharing purchasing arrangements.

Question 29

Tasty Chicken has been buying its animal feed in the open market. It notices that about 10 percent of its purchases are watered down, so that the feed seems to weigh more than it actually does. To improve quality of its purchases, Tasty Chicken might consider:

A) moving to long-term contracts with specific feed producers.
B) hiring an economist to see if the market is really competitive.
C) lobbying for new laws concerning water levels in feed.
D) going out of the chicken processing business.

Question 30

Agri-Tech supplies a patented sweetener to various food processors. It has noticed that the value of the sweetener varies dramatically from one buyer to another, depending on the end-use demand. But its experiments with charging higher prices to some buyers have failed because:

A) price discrimination is always illegal.
B) of market arbitrage.
C) the cost of production is always the same.
D) outsourcing is compromised by contracting costs.

Question 31

SUVmart wants to buy its quota of 250 Rhinos from AutoCorp. For the quota system to work efficiently AutoCorp must commit credibly to the:

A) exclusive territory.
B) double markup.
C) retail price.
D) wholesale price.

Question 32

When asset specificity is very high and there is a lot of market uncertainty, then it is best for a firm to:

A) buy in the open market.
B) use a long term contract.
C) vertically integrate.
D) engage in a joint venture.

Question 33

A firm that produces its own output is engaging in ________ integration, while a firm that markets its own good is engaging in ________ integration.

A) vertical; horizontal
B) downstream; upstream
C) forward; backward
D) backward; forward

Question 34

Independent distributors of soda can free ride on the name brand of the producing company. Two solutions to this problem are:

A) joint asset ownership and long term contracts.
B) open market transactions and free distribution of production secrets.
C) linked advertising and exclusive territories.
D) open market transactions and exclusive territories.

Question 35

When asset specificity is very low and there is no market uncertainty, then it is best for a firm to:

A) buy in the open market.
B) use a long-term contract.
C) vertically integrate.
D) engage in a joint venture.

Question 36

AutoCorp is a dealership that has a contract that prevents the main company from opening another dealership within a 30 mile radius. This is an example of:

A) company free-riding on AutoCorp's specific asset: local monopoly.
B) AutoCorp free-riding on the company's reputation.
C) exclusive territories.
D) double markups from locational advantages.

Question 37

Double markups refer to the tendency of the:

A) manufacturer and the distributor to increase the product's price above AC.
B) manufacturer to increase the product's price by more than twice the MC.
C) distributor to increase the product's price by more than the manufacturer.
D) manufacturer and the distributor to increase the product's price above MC.

Question 38

Two contract terms that reduce transfer pricing problems are:

A) double markups and two-part pricing.
B) quotas and double markups.
C) exclusive territories and two-part pricing.
D) two-part pricing and quotas.

Question 39

Andy Freeman is a sales representative in a rural area, selling herbicides to farmers. He drives close to 1,000 miles every week that he is on the road. Many of the miles are on dirt roads. From an asset ownership point of view, what type of car should he buy?

A) A large SUV
B) A foreign car like a Mercedes
C) A pick-up truck with an extended cab
D) A rental car

Question 40

LightCo sells fairly standard light bulbs to Bodyworks, while BodyWorks sells components that can only be used by AutoCorp. Why is LightCo only interested in price while BodyWorks hires a law firm to negotiate its contracts with AutoCorp?

A) LightCo and BodyWorks both have significant alternatives in the marketplace.
B) LightCo has market alternatives while BodyWorks does not.
C) BodyWorks has market alternatives while LightCo does not.
D) Neither LightCo nor BodyWorks have market alternatives.

Question 41

Nonmarket transactions refer to:

A) purchase in the a spot market.
B) horizontal integration.
C) long term contracts.
D) market power

Question 42

Independent distributors of a brand name product:

A) cannot free-ride on the product's reputation and produce optimal sales.
B) can free-ride on the product's reputation and produce optimal sales.
C) cannot free-ride on the product's reputation and produce suboptimal sales.
D) can free-ride on the product's reputation and produce suboptimal sales.

Question 43

Two contract terms that reduce free-rider problems are:

A) double markups and two part pricing.
B) advertising provision and double markups.
C) exclusive territories and double markups.
D) advertising provision and exclusive territories.