The History Of Managerial Economics

Published Date: 02 Nov 2017

Managerial Economics

The production of any good or service usually requires a series of activities organized in a vertical chain. Production activities normally flow from upstream suppliers of raw inputs to downstream manufacturers, distributors or retailers. "The greater a firm‟s ownership extends over successive stages of the value chain for its product, the greater the degree of vertical integration" (Grant, 2010, pp354). In this essay the vertical integration with its embedded transaction cost economics will be explained and studies mainly against Gulf Business Machine (GBM). GBM is IBM business partner and sole distributor for IBM software in the Gulf region.

Transaction Cost Economics (TCE)

In the neoclassical economics, firm is viewed as a set of production plans managed by a manager. The manager will control the processes of selling and buying outputs and inputs from the market to maximize the profit of the owners. This neoclassical theory got complimented by the principal-agent theory. Principal-agent theory addresses manager’s behavior and the conflict of interest between different actors in the economic process.

In the efforts of enhancing economic theories and trying to answer the fundamental questions regarding firms and its boundaries, Coase (1937) explained that there are associated costs –transaction costs- for each exchange transaction when firms use the market and its mechanism. Mainly costs are the costs for thinking, planning, price discovery, costs of negotiating and finalizing the contract.

Vertical Integration

The vertical boundaries of a firm define the activities that the firm itself performs as opposed to purchases from the market (Beasanko).In general the firm usually uses the internal mechanisms to produce its output as long as the internal cost of running these mechanisms with its associated economic costs is less than executing the same transaction within the market. The firm should use the market if the cost of making the transaction within the market along its associated economic costs is less than carrying it internally.

The decision of whether to vertically integrate either backward –closer to the supplier- or forward –closer to the consumer- is not a straightforward decision. Managers should understand TCE, bounded rationality, opportunism, hold-up and others when evaluating the make-or-buy decision. Defining GBM boundaries is critical for performance, especially in high-technology industries (Teece, 1986, 1992; Bettis and Hitt, 1995).

Make-or-Buy Dilemma in the Strategic Outsourcing

GBM in general in addition to selling IBM software is doing IT services. In the IT services business, GBM faces the make-or-Buy dilemma in terms of building its own team vs. strategic outsourcing. Being handling a large IBM software portfolio, GBM has two extreme decisions alternatives. First, GBM to hire all kind of product specialist, technology specialist, project managers, designers and IT architects to be able to run and deliver all services business entirely independent. Second, GBM outsource all of its technical service activities to external vendors and business partners and focus only on the sales and business development. Accordingly GBM seeks to identify the most effective balance in both organizing alternatives to leverage their benefits and mitigate their costs. The dilemma is to find the optimum balance point between these two alternatives that maximize both the economy of scale in terms of the number of projects that GBM can deliver in parallel and the economy of scope in terms the diversity of specialty that GBM can claim to work-on.

To achieve this balance point GBM trying to be partially integrated and simultaneously outsource some activities (Harrigan, 1984; Afuah, 2001). Rothaermel et al. (2006) label this type of organizing approach taper integration, which occurs ‘when firms are backward or forward integrated but rely on outsiders for a portion of their supplies or distribution’ (Harrigan, 1984: 643). Accordingly, GBM strategy is to hire the senior level people such as project managers. IT architects and senior specialists and outsource the development and testing to external vendors.

Asset Specificity in Strategic Outsourcing

An asset is ‘specific’ if it makes a necessary contribution to the production of a good and it has much lower value in alternative uses (Klein et al., 1978). According to McCarthy and Anagnostou (2004), outsourcing not only purchases services from sources that are external to the organization, but also transfers responsibility for the business function and often the associated knowledge to the external organization.

Differences in outsourcing services may also be based on the existence of specific investments to specific client needs. For example, GBM ran a time and material contract for a government entity in Qatar that end up supplying more than 30 persons. GBM decided to hire all these resources internally to maximize the profit and to control the deliverables quality. This kind of investments can be argued to be sunk costs for the GBM but the relevant issue is that these kind investments is very specific to client need.

As transaction cost economy indicates, the more specific the assets involved in the transaction, the more probable opportunistic behavior is and, therefore, in-house provision becomes more likely. It reinforces the need to take into account the specificity of each of the services (Merino and Rodríguez, 2007). This kind of client specific contracts demonstrates the asset specificity issue. In GBM case, when the government entity management team changed, they decided to reevaluate the contract and ended up to select another vendor and terminate the contract. GBM had the dilemma of either keep the resources and try to utilize them in other projects or fire them and try to recover from the bad reputation in the recruitment market. GBM decided to fire more than 20 people who get hired for a specific contract and specific customer needs as it failed to utilize them on other running or near feature projects.

Hold-Up and Opportunism in Strategic Outsourcing

According to Holmström and Roberts (1998) the last two decades of research about the boundaries of firms has emphasized the importance of "hold-up" problems between transacting parties. Additionally, asset specificity, hold-up and opportunism are all interrelated topics.

In some circumstances, when GBM searching the market for a vendor, there may be a considerable number of relevant vendors in the market that can do the job. The degree to which the activity being outsourced is affecting the opportunism costs. If the market for the activity is competitive, opportunism gets lower at both contracting stage and potentially at the post-contract stage. Low competition raises issues in the contract and post-contract phases. During contract negotiations, a potential vendor in a market with a limited competition is most likely to offer services at a price above average cost. This can be thought of as a bargaining cost, as it is part of the outsourcing cost in general.

During contract negotiation, GBM does not have all the required experts internally to judge the external vendor effort and plan, this kind of asymmetric information and bounded rationality give external vendors stronger position in the negotiation specially if there is a low competition with this specific vendor.

At the post-contract stage GBM risks of opportunism increases with its associated costs for two reasons. First, the contracted vendor cannot be quickly replaced. Second, there is a high risk of ‘contract breach’. This risk is especially relevant when the external vendor provides services that are strategic to the GBM customer. For example, a vendor carrying out payroll operations or streamline business operations can jeopardize GBM customer relation.

Hold-up problem arises almost with every contract GBM undergo with vendors. Usually GBM outsource to overseas companies especially Indian ones. The hold-up issue arises after GBM get awarded the deal and sing the contract with the customer. At this point GBM as a local company face all legal risks as part of its commitment to deliver the solution on-time and within budget. The subcontracted overseas companies do not face this kind of legal risks. GBM take the risk on behave of the subcontracted companies for the overall solution on both technical and commercial aspects. To mitigate this risk, GBM usually add a considerable mark-up on top of the subcontractor cost. This mark-up mitigate the risk of extra effort needed from internal GBM resources, change request from the subcontracted companies or even switching cost on case of terminating the contract with the subcontracted company and search for another one to carry on the work. This mark-up introduce another issue, the overall price will be over priced and not competitive with other local companies who add much smaller mark-up, hiring cheap local resources or ultimately effectively integrated vertically with low prices vendors

Nexus of Contracts

In addition to the previous contract issues, typically GBM projects incorporate different types of contracts both internally and externally. Internal contracts include contracts within different GBM internal departments like business solutions, networking, software, hardware and managed operations. Each department may carry on part of the job and outsource the remaining to other external vendors. This demonstrates a nexus of contract issue. There is an amount of uncertainty in these contracts during the quality check and the validating process to ensure delivering what promised across the supply chain. This type of uncertainty force GBM to incorporate an additional cost to mitigate this risk of uncertainty. This also requires coordination which can be a problem given that GBM needs to obtain economies of scale and size in order to be profitable. Accordingly, GBM prices become not competitive given that customers rational and maturity in this region specifically in the IT industry is relatively low and usually seek low prices over quality.