VALUE CHAINS AND ROLE OF DISTRIBUTION

To address the topic of forward integration, it is helpful to understand the roles and functions assumed by different firms along the value chain and why industry segregation seems to appear inside the value chains.

46 1.0 Value chains and industry roles

Industry value chains in their basic form are defined as “the process by which technology is combined with material and labor inputs, and processed inputs are assembled, marketed and distributed” (Kogut, 1985: p.15). Various links in this process may be constituted by individual firms or by larger vertically integrated firms. Hence, the boundaries of a firm can range from a focus on specific product markets to span across multiple industries along horizontal and vertical value chains (Pindyck and Rubinfeld, 2013). The industries are constituted by firms that compete in the specific product market along the value chains, supplying similar or closely related products and services. The interactions between buyers and sellers in these product markets determine the configuration and price of different products offered in the markets (ibid).

The value chains may also have industries of networked firms where leading ones can act as

‘hubs’ collecting inputs from various suppliers for further distribution (Gereffi, 1994, Gereffi et al., 2005, 2018). In this context two typologies can be identified as producer-driven and buyer-driven networks respectively. Producer-buyer-driven networks are typically characterized by heavy investments in production facilities with a focus on low cost operations controlled by the lead firm. We find examples of this structure in a range of industries from traditional car manufacturing to modern windmill production. Buyer-driven networks are typically more labor-intensive downstream activities where the retailers’ knowledge about alternative product designs and local market requirements are important (ibid). We find examples of this in the apparel industry exemplified by the Spanish fashion retailer ZARA or the American company Proctor and Gamble in consumer goods.

An organization’s value-adding activities are laid out by the technical rationality deployed in order to serve its domain. In other words, they satisfy market demands through the products and services offered to the (geographical) population served (Thompson, 1967). The technical rationality can be assessed by its instrumental and economic effectiveness. Instrumental effectiveness is determined by the degree to which the specified activities and deployed resources achieve the desired outcomes demanded in the product markets. Economic effectiveness is determined by the degree to which revenues exceed costs (ibid) and allow the firm to generate profits and survive (Alchian, 1950; Fama and Jensen, 1983). The individual firms must decide how to govern the internal value chains across different industries or output markets, determining the location of authority to deploy firm resources. They must also resolve the need for entrepreneurial responses to product complexity and market opportunities (Miles et

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al., 1978) at different stages of outputs along the value chain. This may entail specialization and development of specific organizational structures where resources and competences are deployed in unique combinations (Mintzberg, 1979; Prahalad and Hamel, 1990). Resources can comprise both tangible and intangible assets, in addition to action-oriented competences with an ability to apply resources for specific outcomes (Nooteboom, 2004).

For firms that decide to integrate parts of the external value chain, this can be achieved by internal growth or through mergers and acquisitions (Riordan, 2008). Vertical integration can take two directions: (1) Upstream or backward integration, when the firm integrates manufacturing of inputs and intermediate products and services needed to complete the final product, and (2) downstream or forward integration, when the firm integrates subsequent business activities that further refine the final product towards a more complete offering and subsequent activities like sales, distribution and servicing of the final products. The integration of business activities can range from ‘full’ integration where all inputs are owned, to ‘taper’

where part of the inputs are sourced outside. The number of sequential stages in the value chain to be internalized can vary as can the number of different input and output sources at each stage along the value chain (Harrigan, 1986; Kogut, 1985).

This is illustrated in Figure 1 (below) showing multiple markets and industry stages along a simple value chain from raw materials to the final product market. Firm 1 is supplying a raw material that is processed through different stages to firm 3 that distributes the goods in final product markets. The manufacturing firm’s (firm 2) internal value chain is comprised of tree internal stages symbolized by circles. Firm 2 might have several suppliers at the different stages and may supply the finished products to one or several distributors (firm 3) that handle the last stage of value-adding activities towards different end-users in the final product market. In other words the various product markets along the value chain bind and bridge sequential industries with different technologies to eventually reach the end-users of the final product. The X-axis symbolizes the length and stages of internal activities by each firm and also depicts the different product markets that separate industries. The Y-axis indicates the value enhancement contributed by the industry specific technologies with their different resource combinations and competences deployed along the value-chain.

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Figure 1. The value chain from raw material to finished products.

[Firms assume different roles and add complexity to the adopted organizational technology along the value chain.

The SIC/NACE industries are often considered as distinct markets with normal ’break points’ between them as denoted by the markets 1 to 3. The letters a-b and c-d represent variance in industry break points.]

When firms within each of the industries transform sourced inputs into outputs and compete in the adjacent product market, they possess different resources and competences, in addition to operating different organizational technologies and business models (Thompson, 1967; Teece, 2010). In a long-linked value chain, one industry activity depends on the successful completion of adjacent product inputs and its supply of value enhanced outputs. The employed technology draws on different inputs to generate finished products and achieve the stated business goals.

The chosen combination of diverse inputs is partially determined from feedback about market needs related to the use of the finished product.

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A long-linked organizational technology can combine with a mediating technology (ibid).

This is where a mediating organization connects the output manufactured by the long-linked organization with demands from final product markets. This can comprise the sale of both semi-produced and finished products when the manufacturing firm is not dealing directly with the final users. These interactions will be handled by independent intermediary distributors for whole-selling and the like. The whole-sellers provide an interaction service introducing a business model (Teece, 2010; Baines and Lightfoot, 2014) that relies on a stock portfolio, scale and scope economies, geographical location, and local market knowledge without exerting any influence on the upstream manufactured products. The combination of long-linked and mediating technologies can also comprise more complex settings; the mediator’s business model adds value based on use of own idiosyncratic resources, capabilities, and knowledge to transform the manufactured products to forms that better serve the end-users in the final product markets. This implies incorporation of a more intense mediating technology where the instrumental effectiveness in relation to final products is based on interactions and feedback between the manufacturers along with various actors in the product markets. These interactions can enable a higher degree of product differentiation, including more advanced and personalized value adding features (Baines and Lightfoot, 2013).

The different industries can often be defined by their tangible products that are easy to observe. At other times however, in the case of more specialized and differentiated product market offerings, the industry context is somewhat blurred. In the context of long-linked technologies, the output of an upstream manufacturing firm might find use for its products in many different downstream industries. For example, an upstream industry with a relative simple commodity-like product, such as petroleum, provides input to many different industries like gasoline, plastics, and tires. However, it is hard to imagine that an upstream petroleum producer integrates all aspects of the downstream industries where the petroleum finds use. Otherwise the integrated firms would be much larger than we normally observe and closely resemble planned economies. In other instances the deployed organizational instrumentality resembles that of the adjacent industry where the managerial and operational capabilities (Thompson, 1967) employed to execute them are similar to the adjacent firm. This can be illustrated by the sigmoid (S-curve) function along the value chain induced by manufacturing firm 2 between the adjacent industries 1 and 3 (Figure 1). The significant increase in value-creation from point ‘b’ to ‘c’

depicts an instrumentality that is distinct from firm 1 and 3 in the supplying and distribution

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industries. In contrast, the almost identical slope between point ‘a’ to ‘b’, and ‘c’ to ‘d’, presents similar instrumentality between firm 1 and 2 and firm 2 and 3 respectively with comparable technologies used in the adjacent industry. This instrumental similarity can make this marginal activity subject to easier shifts along the value chain, easier to integrate, and coordinate.

When the instrumentality of manufacturing and the implied managerial resources and capabilities deployed are similar or familiar to the adjacent industry, integration becomes simpler and more predictable (e.g., Barney 1999; Demsetz, 1988; Connor and Prahalad, 1996).

Conversely, when the instrumentality applied in the manufacturing is very distinct from the adjacent downstream industry, the managerial challenge of forward integration becomes more demanding. Differences between deployed instrumental activities, operational capabilities, managerial competences, and organizational features similar coordination mechanisms, control systems, incentive structures, etc. complicate the integration and governance of different business models (Argyres, 1996; Demsetz, 1988). This presents a number of challenges to organizations that contemplate forward integration. They must consider the diversity of business activities and which stages along the value chain the integration should stretch before reaching the final product markets. Reverting to the example of a petroleum company, it does not possess the all the necessary competences and capabilities to integrate with the many different industries that use their product without delegation of authority to lever the use of specific resources, capabilities, and knowledge (Coase, 1937; Chandler, 1977; Demsetz, 1988; Jensen and Meckling, 1990).

The discussion of industry value chains often assumes that product markets are characterized by spot transactions. This, unfortunately, leaves out considerations about the distribution of responsibility, authority, and contractual arrangements to govern the interdependencies between firms. When firms transact in spot markets they are individually responsible for solving their entrepreneurial challenge and instrumental effectiveness and remain the sole residual claimant to the consolidated revenues and profits. This means that each firm specialize its resources, competences, and capabilities related to the product complexity within its own industry and related product market to ensure its own economic returns. But, trading partners in adjacent industries may develop interdependencies over time where investments are made to increase efficiencies in the relationship to the adjacent trading partner.

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They begin an effective and fundamental transformation by gearing their investments to enhance transactions with specific trading partners (Williamson, 1985). This can be the case when one firm offers the other exclusive rights to the sale of a product, or commits to a certain way of doing business in return for specialized investments (Klein, 1995; Lafontaine and Raynaud, 2000). In these situations, the specialized asset specific investments (Klein et al., 1978;

Williamson, 1979) are sources to future jointly generated profits while also increasing the costs of leaving the trading relationship.

Based on this general discussion of value chains, we will now investigate the economic rationales developed to assess the viability of forward integration among manufacturing firms into downstream distribution and value-adding activities.