The production of any particular good consists of a number of stages (Skousen, 2007). The beginning is when a company acquires raw materials and ending with the distribution of its manufactured goods and services to the end customers. The entire system can be collectively called a vertical chain (Besanko, et al., 2009). The main challenge to any entrepreneur is to organise various components of the vertical chain of a company.
In order to understand the concept of vertical boundaries of a firm, the role of transaction cost has gain enough support from eminent economists like Oliver Williamson, in 2009 explained the role of transaction cost economics while defining the boundary of a firm (Martins, et al., 2010). Transaction cost is the cost that a company has to incur in order to participate in market activities (Schneider, 2014). This paper illustrates how a company can come to a negotiation so that they can eliminate transaction cost in order to achieve efficient outcome.
According to Coase theorem, in an economy with no transaction cost, trade will provide efficient outcome but the only requirement would be well defined property rights (The Economists, 2010). In absence of transaction cost, if an individual wish to sell his car which has value attached to it, the first requirement is to own a car in the beginning. In the later stage, the car will be sold to the highest bidder so that the owner can reap the entire surplus (Todorova, 2007).
Effect of the Presence of Transaction cost: In the modern economy, individuals and companies have to incur transaction cost so that they can own resources which can be utilised by the concerned owner to earn profit. Considering the same example, in a modern economy, if an individual has to sell a car then the seller has to find potential buyer who will negotiate over the price and there will be the intervention of a governing body that will enforce the transfer of property rights (Martins, et al., 2010). In simple words, legal cost of the transaction has to be incurred by both the parties.
A firm in order to reach an efficient outcome with increasing positive returns on the invested capital would require that it has to incur minimum transaction cost. The accomplishment of this objective requires firms to negotiate it with its suppliers (Federal Trade Commission, 2005). If a firm can obtain input at the lowest price, then it will have the opportunity to raise its profit. A firm need to find suppliers who will provide the raw materials at the lowest cost and this search involves cost. Again, the firm will have to engage in bargaining so that it can lower the cost incurred for production. After obtaining the raw materials in order to produce the output, the firms need labour who will put the required effort to transform input into output.
In case a firm need to introduce a change which can increase the efficiency of its production process, it finds itself in a dilemma, whether to incorporate it within its organisational structure or outsource it to those who have the required skill set present and finally, there will be distribution cost to reach to the final consumers. In context to this, it is very important to understand the role of vertical integration because it has been one of the most preached ways of reducing transaction cost. For example, a firm acquires one of the raw material producing firm them it can produce final goods at a lower cost while selling them to other buyers will cover the cost of acquisition. All the activities performed within a firm will be fall within the vertical boundaries of the firm.
Firm can either vertically integrate with the resource provider or purchase the resources from those who produce them best. This is known as the dilemma of make-or-buy (Williamson, 2013). However, a firm need to value its profit from both the alternatives before it chose either of the options. In this case, the role of market competition plays an important role. This is explained with the help of the following example.
There are two companies, company A and company B; company A is a cycle manufacturing company while company B is engaged in producing tyres. Company A in order to reduce its transaction cost has two options either establish a plant producing tyres or purchase the same from company B.
Figure 1: Cost of production of tyres
(Source: Author’s Creation)
There is L-shaped cost curve representing economies scale. The minimum level of output at which the average cost (AC) is lowest is Q* and the corresponding cost is C*. If company A decides to produce Q” amount of cycles, in this case Q” > Q*; then it is profitable for the company to produce on its own. From the above figure it can be observed that the corresponding cost of producing Q” will approximately equal the AC of C*; hence, from the perspective of the cost, company A will not be able to obtain any benefit by opting to buy it from company B.
If the firm decides to produce Q’ number of cycles where, Q’< Q*, company A will have to incur higher than minimum cost of C’ which is greater than C*. In this case, if the firm chooses to produce tyres on its own, it cost the company more. However, it can produce more tyres than its total production of cycles and sell it to other cycle manufacturing firms. In this case, other rival firms of company A may not be ready to buy from it. In this case, it would be more profitable for company A to purchase tyres from company B rather than producing on its own. However, if the market of cycle manufacturing is competitive, then the price of the tyres will reach to the level of C*. However, if the number of competing firms is less; then the price of tyres will be somewhere between C’ and C* benefiting both the firms in earning profit reaching an efficient market outcome. Hence, it is very important for the firm to consider the benefit coming from both the options, making or buying along with the nature of rivalry in the market.