Deck 19: Vertical Integration and Outsourcing

Question 1

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

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

Answer 1

C

Question 2

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 internally is that:

A)the firm will find it too easy to manage quality.
B)the firm will not be able to minimize costs over the long run.
C)outside competitors will learn about the quality of inputs.
D)the firm will get prompt supply of the input.

Answer 2

B

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

Starting 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 - 30 Q
Or 30 Q = 170 or Q = 5.67 units and so P = 200 - 15(5.67)= $115
So in the retail markets the drugs will be priced at $65 and $115respectively.
The wholesale drug will cost $115 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 $65,and drive DrugCo out of business.

Question 4

When 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,it is said to be:

A)integrating downstream.
B)integrating upstream.
C)franchising.
D)outsourcing.

Question 5

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 6

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 7

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 8

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 9

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

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

Question 10

What is outsourcing and what forms does it take?

Question 11

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

Question 12

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

Question 13

Why aren't all economic transactions conducted through markets?

Question 14

Agri-Tech supplies is 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 highly price elastic while the demand for sweetened medicine is relatively less elastic.Can Agri-Tech find a way to successfully price discriminate?

Question 15

The nonmarket transactions refer to:

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

Question 16

When a firm purchases a part of its supplies from any one of a large number of potential suppliers at the current market price without long-term commitments,it is:

A)making a spot market purchase.
B)practicing arbitrage.
C)integrating upstream.
D)integrating downstream.

Question 17

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

Question 18

Nonmarket transactions refer to:

A)purchases in the spot market.
B)horizontal integration.
C)long-term contracts.
D)purchases in the international market.

Question 19

An iron and steel manufacturing plant was facing a power crisis on a daily basis.The unit had to stall production for about two hours on an average per day.In order to minimize the loss,the owner decided to invest in a cogeneration unit that would produce enough power to facilitate production during the peak load hours.This action of the manufacturer exemplifies:

A)a monopoly-pricing strategy.
B)a forward or downstream integration.
C)a dual-pricing strategy.
D)a backward or upstream integration.

Question 20

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 food manufactured by Tasty Chicken.What needs to be done?

Question 21

Catering,trucking,copying,and mainframe computing are among frequently outsourced services because these activities:

A)require assets that are highly firm specific.
B)are not specialized.
C)have a high level of uncertainty.
D)have a relatively low potential for holdup actions.

Question 22

Which of these is an important determinant of contract duration as suggested by the economic models on franchise contracts?

A)Asset ownership
B)Market power
C)Residual rights
D)Recontracting costs

Question 23

Which of these motivate a firm to use nonmarket transactions to acquire inputs and downstream services?

A)Zero transaction costs in the spot market
B)Absence of market power
C)Steady supply of the key input used in production
D)Imposition of low tax rates on a particular production unit

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

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 26

AutoCorp is a reputed automobile manufacturer while SUVmart is an independent distributor who buys automobiles from the former.During the current year,SUVmart wants to buy 250 Rhinos from AutoCorp who wants to charge an upfront franchise fee.The franchise fee charged by it:

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

Question 27

AutoCorp is a reputed automobile manufacturer while SUVmart is an independent distributor who buys automobiles from the former.During the current year,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 28

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 achieved at the equilibrium price.
B)not costless.
C)always result in a price that clears the market.
D)hindered by technological change.

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

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 inputs are available in adequate supply in the market.

Question 31

A major advantage of long-term contracts over short-term contracts is that they increase the incentives of the contracting parties to:

A)practice holdup actions.
B)practice arbitrage.
C)undertake spot market transactions.
D)make firm-specific investment.

Question 32

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

A)creating joint asset ownership and entering into long-term contracts.
B)encouraging open market transactions and distributing production secrets.
C)advertising and granting exclusive territories.
D)encouraging open market transactions and granting exclusive territories.

Question 33

Which of these contract terms reduce transfer pricing problems?

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 34

If an important component of a firm's production process 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)incur information cost.

Question 35

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 36

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

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

Question 37

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

Question 38

When asset specificity is very low and there is no market uncertainty,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 39

Double markups refer to the tendency of the:

A)manufacturer and the distributor to increase the product's price above the average cost.
B)manufacturer to increase the product's price by more than twice the marginal cost.
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 the marginal cost.

Question 40

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 41

Independent distributors of a brand name product:

A)can commit to provide aftersales service to bulk purchasers.
B)can announce discounts on the product price to improve sales.
C)can increase its marked price to meet shortage of stock.
D)can free-ride on the product's reputation and produce suboptimal sales.

Question 42

Granting exclusive territories to distributors:

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 43

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)a local monopoly.
B)branding.
C)an exclusive territory right.
D)a double markup.