Make versus buy
Backward integration: A company exhibits backward vertical integration when it controls subsidiaries that produce some of the inputs used in the production of its products.
Forward integration: A company tends toward forward vertical integration when it controls distribution centers and retailers where its products are sold.
Make and buy are however two extremes along a continuum of possibilities for vertical integration.
Economists say that early steps in the vertical chain are upstream in the production process and later steps are downstream.
May firms have succeeded performing their own processing, handling, and support activities, others buy them from specialists in the market, or what we call market firms. By using these firms, a manufacturer can obtain a superior marketing program, rapid and low-cost distribution, and accurate reports about payroll, sales, and inventories without having to perform any of these tasks itself.

Defining boundaries
To resolve make-or buy decisions the firm must compare the benefits and costs of using the market as opposed to performing the activity in house

Benefits of using the market
- Market firms can achieve economies of scale that in-house deparmtnets producing only for their own needs cannot
- market firms are subject to thediscipline of the market and must be efficient and innovative to survive. Overall corporate succes may hide the inefficiencies and lack of innovativeness of in-house departments.

Costs
-Coordination of production flows through the vertical chain may be compromised when an activity is purchased from an independent market firm rather than performed in-house
-Private information may be leaked when an activity is performed by an independent market firm
-Tere may be costs of transacting with independent market firms that can be avoided by peforming the activity in-house.

Some make-or-buy fallacies:
- Firms should make an asset, rather than buy it, if that asset is a source of competitive advantage for that firm
- Firms should buy, rather than make, to avoid the costs of making the product
- Firms should make, rather than buy to avoid paying a profit margin to independent firms. (accounting profit and economic profit, expertise)
- Firms should make, rather than buy, because a vertically integrated producer will be able to avoid paying high market prices for the input during periods of peak demand or scarce supply. (Contracts with suppliers
Firms should make, rather than buy, to tie up a distribution channel. They will gain market share at the expense  of rivals. This claim has merit on some occasions, but it used to justify acquisition on many other occasions when it lacks merit.
Economists have identified a number of special cases in which foreclosure may succeed. One example involves an upstream monopoly supplier that is unable to commit to a high price when selling to downstream firms. Another example is when an upstream firm is "rolling up" (i.e., acquiring) several downstream firms to create a netork.

Reasons to buy
Firms use the market primarily because market firms are often more efficient. Market firms enjoy two distinct types of efficiencies: They exploit economies of scale and the learning curve, and they eliminate bureaucracy.

Exploiting scale and learning economies
Firms should focus their activities on what they do best there are several reasons for this:
- market firms may possess proprietary information or patents that enable them to produce at lower cost.
-They might be able to aggregate the needs of many firms, thereby enjoying economies of scale. (market firms can often aggregate the demands of many potential buyers, whereas a vertically integrated firm typically produces only for its own needs.

Bureaucracy effects: avoiding agency and influence costs
Bureaucracy includes a number of specific problems associated with agency and influence costs.

Agency costs
Agency costs are the costs associated with slack effort and with the administrative controls to deter it. Agency costs reduce the firm's profitability because workers take steps in their own best interests, which are not necessarily the best interests of the firm. Agency costs and the associated loss of profits may go unnoticed by top management in a large vertically integrated firm. One reason is that most large firms have common overhead or joint costs that are allocated across divisions. This makes it difficult for top management top management to measure and reward an individual division's contribution to overall corporate profitabilty. A second reason is that in-house division in many large firms serve as cost centers that perform activities solely for their own firms and generate no outside revenue. Cost centers are often insulated from competitive pressures because they have a committed "customer" for their inputs. It can be difficult to evaluate the efficiency of cost centers because there is often no obvious market test for judging their performance.
- They might exploit their experience in producing for many firms to obtain learning economies.

Influence costs
Influence costs include not only the direct costs of influence activities (e.g., the time wasted when a division manager lobbies central management to overturn a decision t hat is unfavorable to his or her division). They also include the costs of bad decisions that arise from influence activities (e.g., resources that are misallocated because an inefficient division is skillful at lobbying for scarce resources.

Reasosn to make
The three major costs associated with using the market include:
-costs of poor coordination between steps in the vertical chain
-reluctance of trading partners to develop and share valuable information
- transaction costs.

The economic foundations of contracts
Contracts are valuable, because they list the set of tasks that each contracting party expect the other to perform. But contracts also specifiy remedies in the event that one party does not fulfill its obligations. Contracts are writeen to protect parties to a transaction from opportunistic behavior. However contracts are not equally effictive under all circumstances. Their effectiveness depends on:
- the completeness of the contract
- the available body of contract law

Complete versus incomplete contracting
A complete contract eliminates opportunistic behavior. A complete contract stipulates each party's responsibiliteis and rights for each and every contingency that could conceivably arise during the transaction.
The requirements for complete contracting are severe:
-parties to the contract must be able to contemplate all relevant contingencies and agree on a set of actions for every contingency.
- The parties must also be able to stipulate what constitutes satisfactory performance and must be able to measure performance.
- The contract must be enforceable.
Three factors that can prevent complete contracting are:
-Bounded rationality (refers to limits on the capacity of individual to process information, deal with complexity, and pursue rational aims.
- Difficulties specifying or measuring performance (vague language, open ended
 - Asymmetric information (parties do not have equal access to all contract-relevant information, if one party knows something that the other dooes not, then information is asymmetric, and the knowledgeable party may distort or misprepresent that information.

The role of contract law
A well-developed body of contract law makes it possible for transactions to occur smoothly when contracts are incomplete. The doctrines of contract law specify a set of "standard" provisions applicable to wide classes of transactions. Contract law is not a perfect substitute for complete contracting for two important reasosn:
- Doctrines of contract law are phrased in broad language that is open to differing interpretations when applied to specific transactions
- Lititgation can be a costly way of "completing" contracts
the termination of long-standing business relationships as a result of a breach-of-contract suit can be especially costly if the parties have invested in the relationship and become mutually dependent on one another.
By now it should be clear that contracts are an imperfect way to ensure that trading partners perform as desired. If the resulting inefficiencies are large enogh, it might make sense to take production in-house choosing make over buy
Inefficiencies might be especially large:
- when it is important to coordinate activities in the vertical chain,
-when firms must share vital information
- when firms must make crucial investments

Coordination of production flows through the vertical chain
For coordination to succeed, players must make decisions that depend, in part, on the decisions of others.
- timing fit
- size fit
- color fit
- sequence fit
Design attributes: are attributes that need to relate to each other in a precise fashion; otherwise they lose a significant portion of their economic value

Leakage of private information
Private information may pertain to production know-how, product design, or consumer inforamtion.

Transactions costs
Ronald Coase concluded that there must be costs to using the market that can be eliminated by using the firm. These have come to be known as transactions costs. Tranactions costs include obvious things like the time and expense of negotiationg, writing, and enforcing contracts. They also include subtle and potentially far greater costs that arise when one or more firms exploit incomplete contracts to act opportunistacaly.
Three important theoretical concepts from transactions-costs economics are:
- relationship-specific assets,
- quasi-rents
- holdup problem

Relationship-specific assets
A relationship-specific asset is an investment made to support a given transaction. Firms that have invested in relationship-specific assets cannot switch trading partners without seeing a decline in the value of these assets.
Forms of asset specificity:
- site specificity (assets that are located side-by-side to economize on transportation or inventory costs or to take advantage of processing efficiencies)
-physical asset specificity (physical asset specificity refers to assets whose physical or engineering properties are specifically tailored to a particular transaction. Physical asset specificity inhibits customers from switching suppliers)
-dedicated assets ( an investment in plant and equipment made to satisfy a particular buyer.)
-human asset specificity (refers to cases in which a worker, or group of workers, has acquired skills, know-how, and information that are more valuable inside a particual relationship than outside it.
Fundamental transormation: after making relationship-specific investments firms will have few, if any, alternatives. Their profits will be determined by bilateral bargaining. Once the parties invest in relationship-specific assets, the relationship changes from a large number bargaining situation to a small number bargaining situation.