Manchester Business School Worldwide
Assessment 1 Reference: ME/July10/1
Adegbiji, Olugbenga Bayowa
Student Number: 7504001
In order to achieve profitability, management of organizations are often faced with decisions to perform certain activities within the organization or use the market. This is called make or buy decisions. A firm buys from the market, certain activities along the vertical chain of its production when it is more economically profitable to do so, considering other associated risks. It is either that the cost of making such services internally is higher due to a higher cost of internal co-ordination or that the firm sees opportunity in another firm with more specialization in the production of such goods or services and there is an advantage of economies of scale. Each of the option has its good side and its down side for a particular industry and type of productions. Therefore, organization is often faced with the challenge of being able to draw a line between what to do internally and what to obtain from outside.
Transaction cost economics (TCE) is associated with the coordination of the vertical chain of an organization to achieve cost and production efficiency. This can only be achieved by striking a balance between “make” and “buy” decisions at every stage of the vertical chain to ensure that the firm gets the best of the two worlds in order to achieve efficiency in production and profitability.
Key Characteristics of TCE
Transaction costs refers to cost of using the market that are saved by centralized direction. They include the costs from the expense of negotiating, writing, and enforcing contracts and the cost of opportunist behavior by either of the parties, when one or more parties seeks private gain at the expense of the greater good. Relations specific investment also increases transaction cost. This include the cost of hold-up or opportunist behavior after investment, the magnitude of which can be measured by quasi rent.
According to Vedpuriswar A. V (2003), there are basically two issues to be considered in vertical integration. They are technical efficiency means which deals with least cost production process and the agency efficiency means which bother on exchange of goods and services in the value chain to minimize coordination, agency and transaction costs.
Where the market is superior for minimising production costs, the Vertical integration is superior for minimising transaction costs. The optimal vertical integration in a firm minimises the sum of technical and agency inefficiencies. The structure and the strategy of an organization is therefore informed by the consideration for organizational efficiency through optimal use of resources and the economics of transaction cost. The decision to “make’ or “buy” is always motivated by certain reasons depending on the type of organization, the strategy and the organizational objectives.
Reasons to ‘Make”
- A firm performs certain activities internally if the cost of external co-ordination of the vertical chain is higher than what is obtainable within the organization, which eventually may lead to a higher cost of production.
- Internal co-ordination of the vertical chain may also be employed if there is a high risk of exposing certain sensitive information or trade secrets to an outside firm. This normally happen with high technological or research organization where the risk of losing such an information to a market firm could be dangerous. Where such a risk exist and a complete mitigation plan does not exist, an organization will prefer to perform the task in question within the firm, thus safeguarding the life of the organization.
- A firm may also be vertically integrated if the cost of using the market is too high. This includes cost of putting the right...
References: • Besanko D. et al (2010), “Economics of Strategy”, Wiley 2010
• Coase R. (1937), “The Nature of the Firm”
• Vedpuriswar A. V (2003), “The Vertical Boundaries of the Firm”
Available at www.vedpuriswar.org
• Tan K. (2009), “The Firm”
Available at www.econ.ohio-state.edu
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