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There was a story tossed around at some point about Henry
Ford’s crowning jewel, the River Rouge manufacturing plant. It was said that
Ford, who owned the mines for the coal and iron ore and the plantations of
rubber trees for the rubber, would have the ships unload their cargo on one end
and the other end would spit out fully formed Ford automobiles. This is an
example of perfect vertical integration from tree to tearing up the country
roads. It is also, what may look to be the best way to realize profit in a
market system is vertical integration. A firm will not have to be at the mercy
of suppliers, and they can capture whatever profit the supplier firm might
have, thus creating more profit within the firm.
It is simplistic and wrong. One of the key insights of microeconomics
is that there is a whole constellation of factors to take into consideration
when looking at integration, either vertical or horizontal. These are termed
“make-or-buy” decisions (Besanko et al. p. 99) and they determine if a firm
should obtain an input from a supplier on the market or bring it in-house. The
ultimate takeaway is that the profit the supplier firms create is hard to
capture because the supplier firms have their own learning curve and their own
economies of scale. It may make no sense for an automobile manufacturer to make
their own airbags when every manufacture needs airbags, and a supplier can
specialize and sell airbags to several companies. This allows the supplier to
have lower costs because they are operating at scale where a singular
manufacture of automobiles would have higher costs because they are
manufacturing for only themselves. The potential exist for the manufacture to
be a supplier for other manufacturers, but that is rare because other
manufactures do not want to be reliant on competitors for suppliers. This is
why Delphi and Mopar were spun off the larger parent companies, and they have
gone through further specialization themselves. A further incentive to buy in
the market is that by having multiple suppliers a firm can buy an input at the
market price and be shielded from any supply chain disruption. Competitive
firms do realize a profit, but bringing production of an input in house is no
guarantee of capturing that profit both because the supplier is working at
scale and there is a potential for the supplier to get lost in the bureaucracy
of the firm and the potential profits instead become costs to overhead.
Ultimately, it can be the firm that does the least that is the most efficient
because it can then utilize the learning curve and the economies of scale for
that one thing that they do.
There are other important takeaways of strategic
microeconomics. An important thing to take into consideration is that the
market is not everywhere and anywhere. A lot of goods and services are
available through the internet. Call up Amazon and hope you find a good price
and can trust the reviews, and you can buy most anything near the market price
depending on how you get it shipped to you. Other products are very tied to the
location of the consumer and the supplier. If a particular sweater is only
available in Mongolia, and the firm does not ship it, then the buyer has to
both find the sweater and go to Mongolia to obtain it. The location of a firm
has some very real drivers on how much the customer is willing to pay. The
ultimate cost of a good is not just the price paid in market, but also the time
it takes to find it and get to it. There is the gas paid and the depreciation
of the car, and the opportunity cost involved with the travel. What does a
potential customer give up in terms of going to Mongolia to get that sweater?
It can be so much that the firm could give them away to American customers and
they would not be able to. Instead, the market for that sweater is more
realistically geographically defined. Mitigating these search costs (Besanko et
al. p. 179) is why it is so common to see multiple locations of some stores. In
Chicago, there are Dunkin’ Donuts and Walgreens stores almost every other
block. The reason is that though they sell differentiated products, the next
best option is similar enough they have to put their stores everywhere or else
they will lose potential sales to competitors.
A third important take-away from studying the strategy of competitive
markets is the importance of the demand curve. In macroeconomics, the demand
curve is given and it is more conceptual, but the slope of the demand curve is
important. It is also not wholly a straight line. Individual markets have their
own demand curve, and they can be empirically measured to show the inverse
relationship between quantity and price, so that the demand curve is a downward
sloping line. This has two interesting consequences (Besanko et al. p. 20). First
is that an individual firm’s price flexibility is based on the demand curve.
The less of a slope the demand curve has, also meaning the more elastic that
demand is the less power an individual firm has to set prices. This can be seen
in a perfectly competitive market. All the firms in a perfectly completive
market have to charge the one price that is also the market rate where the
average total cost curve and the marginal cost curve intersect. The downward
sloping demand curve has an important consequence at the other end of potential
market structures, in a monopoly. In a monopoly, the seller has pricing power,
but they still have to face the quantity consequences of that pricing. If they
try to take the price higher, they will lose customers. There is a theoretical
point of price elasticity called perfectly inelastic demand, where the demand
curve is a horizontal line, but that does not reflect the real world. Even in a
world where a company had a monopoly on breathable oxygen, there would be a
slope to the demand curve because ultimately, the willingness to pay would
still be infinite, but the actual ability to pay would be finite. Ergo, there
would be a backwards slope to the demand curve, and the monopolist is price
constrained.
These and other ideas in microeconomics are crucial
takeaways from the science. Some things that may look to be common sense on the
surface are actually more complex once the math is grafted on the too easy
narrative statements. Integration is not always perfect, there is a cost to
search, and the demand curve can be limiting. Any prospective manager, as well
as current manager, should be cognizant of these results of microeconomics.
References
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