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Chapter 19: Vertical Integration and Outsourcing
BIOCHEM PRICING POLICY
Discussion Question Answers:
1. To find the optimal price for each market segment, simply set MR = MC and solve for Q
2. A problem with trying to implement this pricing strategy is arbitrage (it will be hard to
prevent resale across the two markets). BioChem might be able to implement this policy by
integrating forward into the home market. It can obtain its profits in this market through retail
sales and price the chemical product at $150.50 for farm manufacturers. Note that the strategy
OIL INDUSTRY DISTRIBUTION SYSTEMS
Discussion Question Answers:
1. The oil company invests in the direct serve-stations for monitoring, advertising, training, and
so on. They get reimbursed for these expenditures through their gasoline sales. Distributors can
2. The oil company will obviously not continue to invest in the direct-serve stations if all the
benefits go to the distributors. One action they might take is to start closing their franchised units
3. Franchising provides incentives through ownership. Ownership incentives are more important
4. The distributors are likely to have more specific knowledge about the market conditions in
rural areas than the central oil company employees (they are local business people from the
AUTOCORP
Discussion Question Answers:
1. Amalgamated Fabric incurs a sunk cost of 2.34 million per year in debt service if the plant is
liquidated. (Amalgamated has $18 million in debt if it liquidates the plant). Thus, seat prices can
fall $23.40 before it makes sense to liquidate (to $256.60). While Amalgamated loses money at
2. It is important to examine AutoCorp’s costs and benefits from reneging on the contract with
Amalgamated. The benefit is a potential $2.34 million per year in savings on seats. AutoCorp,
however, faces potential costs from taking this action. One important consideration is
AutoCorp’s reputation. Does AutoCorp have a reputation for honoring contracts? If so, it might
be reluctant to cheat Amalgamated out of fear of hurting its reputation. Another issue concerns
3. AutoCorp will depend on Amalgamated to supply seats. Amalgamated might be able to “hold
4. Usually supply contracts include provisions to pass through cost increases. These provisions
can give the parties room for opportunistic actions. Even if the price is agreed, parties can often
find clever ways to hold up the other party. For example, AutoCorp might claim that the quality
5. Amalgamated Fabric is an independent company. Its owners have strong financial incentives
to make money (for example, by keeping customers happy, cutting costs, and so on). If AutoCorp
6. The specific asset is owned by AutoCorp and so Amalgamated faces a less severe hold-up
INSURANCE INDUSTRY DISTRIBUTION SYSTEMS
Discussion Question Answer:
The independent auto insurance agents are more likely to own the client list. Ownership of the
list provides important incentives to provide ongoing client services. The ongoing efforts of
auto-insurance agents are more important than for life-insurance agents. Once a life-insurance
