The Managerial Economics

Assignment 1– Managerial Economics

Assignment reference: ME/9578399/Jan15/1

Student Name: Hadler Favarin Martines

Student Number: 9578399

Date: March 8th, 2015

1. Brief Introduction

As we all know, every company has its own particularities and every business faces different challenges and issues. Therefore, it is very important to highlight that the decision to perform an activity itself or to purchase it from the market may vary substantially, depending on aspects such as business environment that a company works in, size, complexity, market, among others.

What we can observe is that outsourcing is a trend in the business world, since complexity is increasing and technical specialty is being required when a firm produces outputs. (Network World, 2013).

In order to better understand our explanation on this topic and aiming to be didactic and practical, we will recall a company called “Castellar Engenharia Ltda.”, a Brazilian infrastructure and heavy construction company. It´s a family owned fast growing company with total revenues of approximately USD 200 million in 2014. This company was founded by my father in law in 1999 in Curitiba, Paraná.

1. The vertical chain decision process

According to McNutt (2014, p.12), the modern business world is using practices of subcontracting labor and outsourcing production giving rise to network organization. All companies face this dilemma. Should the company integrate more and more operations of its production path? Or should the company outsource whatever is possible with independent firms?

Besanko et al. (2013) argues that vertical chain is considered to be the process that begins with the acquisition of raw materials and ends with the distribution and sales of finished goods and services.

Depending on the company and business that the firm is located in, a company may pursue a vertical integration in order to obtain efficiencies such as cost reduction, expertise, risk exposure, etc. Vertical integration is when a firm expands its business into areas that are at different points of the same production patch. It describes a company's control over many or all of the production and/or distribution steps involved in the creation of its product or service.

Vertical integration is the degree to which a firm owns its upstream suppliers and its downstream buyers (closer to the final consumer) with the goal of increasing the company's power in the marketplace. A company may be more vertically integrated, such as Votorantim, Cosan, etc. or more vertically disintegrated, such as Adidas, Zara, among others. Between both extremes, there is a variety of possibilities such as strategic alliances, joint ventures, franchising, among others.

It is interesting to mention that the vertical integration can be defined from a broader spectrum. Some authors, like Snap, believe that vertical integration is whether the company controls the process, not whether the company actually performs all the tasks. Within this definition, we can recall Apple as having a deep vertical integration, since they control the processor, the hardware and software. (Snap, 2013).

Considering the above aspects, a company has to choose which activities the firm would perform itself and which it would outsource to the market. In order to define its vertical boundaries, a company must compare the benefits and costs of using the market or performing the activity in-house (Besanko et al., p. 101). For each analyzed case and company, the option of making vertical integration or buying in the market may vary.

For example, when Castellar Engenharia is hired to build a highway and in this highway passes a tunnel, the company prefers to subcontract a construction company specialized in building tunnels known to the market as the best tunnel constructor. In this case, the benefit of using the market is very clear, since this company is very efficient and detains specific know how that other companies don’t have. Castellar Engenharia is aware that if she proposed to construct a tunnel, the company should invest a huge amount of money in order to obtain the technology, prepare a specific team of employees, etc. When facing this make-or-buy decision, we can explain its decision using the make-or-buy decision tree.

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                                                        (Besanko et al., p. 126)

Since there are specialized suppliers, having execution capabilities that an in-house unit would not and Castellar Engenharia didn’t find out any significant relationship specific assets, significant coordination problems or significant problems involved in leakage of private information, the company decided to use the market, hiring this tunnel construction company.  

The make-or-buy dilemma is faced by companies very commonly. There is no objective answer on whether is better to make or buy. “Make” is when a company performs an activity itself. The company is performing the activity in-house and “buy” is when a company outsources an activity to an independent firm. Considering Castellar Engenharia, the company decided to “make”, when it decided to perform the transport of asphalt bought of third parties. Since the company has many construction sites and those construction sites doesn’t have a uniform asphalt demand and the logistic interface with the provider was not being successful, recently the company decided to acquire trucks to transport asphalt to its construction sites.

Another example of “buying” carried on by Castellar Engenharia is the acquisition of asphalt concrete for road surfaces. Nowadays the company basically buys this input from the largest asphalt producer in Brazil called “Greca Asfaltos”. When Castellar Engenharia was establish, back in 1999, the management strategy was to produce asphalt in-house for the use of road construction in order to reduce costs. However, after a market research, the company management concluded that “buying” was a better strategy considering that the supplier could produce asphalts with economies of scale (lower cost than if it was produced by Castellar Engenharia), better quality and technical specifications, among others. In this case, Greca Asfaltos is able to exploit scale, achieving greater scale, and thus lower unit costs, dividing this scale efficiency with Castellar Engenharia (the downstream firm that uses the input).  In addition, Greca Asfaltos is subjected to the discipline of the market and must be innovative and efficient to remain in the business.