Competing Value Networks, Incomplete Contracts and IT

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1 Proceedngs of the 8th Hawa Internatonal Conference on System Scences - 5 Competng Value etworks, Incomplete Contracts and IT Evangelos Katsamakas Graduate School of Busness, Fordham Unversty, Y katsamakas@fordham.edu Abstract Does the nature of ndustry competton shft from the level of frm to the level of whole value networks/chans? What s the role of IT n that process? We analyze the structure of competton between value networks n a settng where partners nvest n qualty and the endconsumer market s vertcally dfferentated. The man result s that as qualty at the end-consumer market becomes more mportant the ndustry structure s more lkely to shft to competton between value networks. IT s a crucal enabler of the ndustry shft through a demandsde and a supply-sde effect: (a IT can make qualty more mportant for consumers, and (b IT reduces the cost of nvestment n non-contractbles n buyer-suppler relatonshps. Keywords: value networks, value chans, network organzaton, ncomplete contracts, nformaton technology effects, ndustry structure, non-contractbles, qualty dfferentaton, buyer-suppler relatonshps. Introducton Value networks have attracted sgnfcant attenton n many busness dscplnes. A typcal example of a value network s Csco and ts network of supplers/partners. Many busness observers have clamed that a shft to competton between whole networks (e.g. [, ],[], [4], nstead of competton between frms, s underway n many ndustres, leadng to new ndustry structures. However, the reasons or the condtons of such a shft, have not receved much academc analyss. The goal of ths paper s to contrbute to that drecton. Ths paper focuses on analyzng competton between value networks. The research questons we plan to answer are the followng. What are the attrbutes and desgn dmensons of value networks? What s the nature of competton between value networks? What s the optmal number of supplers under competton? When does the ndustry structure shft to competton between value networks? How does IT affect the competton between value networks, and the shft of ndustry structure? The paper develops a model that captures a two-step ndustry value chan consstng of a BC lnk and a BB lnk. The study of the nteracton between the BB market and the BC market s mportant for IS, because the effects of IT n the BC market may have sgnfcant second-order effects n the BB market and vce versa. That type of effects have not receved much attenton n the IS lterature. We model the BC market as a market n whch consumers have heterogeneous valuatons for qualty. The theoretcal framework we use to analyze the BB market s the ncomplete contracts (IC or property rghts theory [5-7]. We consder a number of ways n whch nvestments by partners affect the end-qualty of the product, e.g. the end qualty s determned by a weghted sum of nvestments or by the smallest nvestment. We defne as overlappng network competton, the competton between two networks that share sgnfcant partners (e.g. supplers. We call parttoned network competton the competton between two networks that do not share sgnfcant partners. A shft from an overlappng to a parttoned network competton consttutes a shft to competton between whole value networks. Frst we revew the lterature on networks tryng to dentfy ther attrbutes and desgn dmensons and open research ssues. Then we dscuss the monopoly value network case. The focus of the paper s competton and n partcular the duopoly network case (the IC lterature typcally assumes an exogenous compettve market opton. We show that the structure of competton between value networks affects the ex-ante ncentves to nvest n non-contractbles (e.g. qualty, nnovaton, nformaton sharng, ntensty of collaboraton etc. and the value that each network s able to capture. We show that parttoned network competton s the equlbrum BB ndustry structure when the qualty of the end products s mportant for the end-consumers. Sharng a suppler dstorts the ncentves to nvest n noncontractbles and therefore the low qualty manufacturers are unwllng to share. ur argument ponts to a dfferent Part of ths research was developed whle the author was afflated wth the IMS department of the Stern School of Busness at ew York Unversty. The author thanks semnar partcpants at YU for useful comments /5/$. (C 5 IEEE

2 Proceedngs of the 8th Hawa Internatonal Conference on System Scences - 5 drecton than recent research on networks that emphasze economes of sharng from a network structure [8], but gnore nvestment ncentves. ur results provde nsghts on the role of IT n the shft to competton between value networks.. vervew of value networks etworks of frms have attracted huge nterest n busness felds snce the last decade. Researchers have wrtten about the network organzaton as a form of organzaton that s not a market, nor a herarchy but somethng n between the two, or a hybrd form of organzaton [9]. The transacton cost economcs lterature [] suggests that networks should be the optmal governance mechansm for ntermedate levels of asset specfcty. etworks have attracted huge nterest n the busness press too. [, ] argue that networks (or value-webs as they call them enabled by the Internet are the new busness models of our era (see [] for a crtque. Csco and ts partners s a typcal example of a value network. [] revews the network organzaton lterature from a socal, economc and computer scence perspectve. [] studes a number of dfferent automotve buyer-suppler networks and fnds a postve relatonshp between buyersuppler co-specalzaton and network performance. A recent stream of economc lterature emphaszes the structural aspects of these networks (see e.g. [8]. [4] descrbes: At GM the soluton was one of ownershp: GM makes a large fracton of ts own components. At Toyota, the soluton was to establsh long-term relatonshps wth a smaller number of key supplers who would make a wde array of components and systems and would be rewarded or penalzed for ther performance when addtonal contracts were awarded for the next car model. Although both systems are responses to the same problems, they are not equally effectve. By the md- 98s, GM had begun adaptng aspects of the Japanese system to ts own operatons. GM reduced the number of ts supplers, bought whole systems nstead of components and establshed closer suppler relatons, to the pont of allowng certan supplers to partcpate n the desgn of the next model. [5] dscusses the contract manufacturng n the electroncs ndustry and proposes the modular producton network as a new form of ndustral organzaton, enabled by IT and standardzaton across dfferent steps of the value chan. Smlar deas are artculated by [6]. The sharng of key supplers s an mportant feature of a modular producton network. Some attrbutes of value networks are (a small numbers of partners, (b ncreased cooperaton, nformaton sharng and ntensty of collaboraton e.g. on product desgn, (c co-specalzed nvestments, (d relatvely long-term, repeated nteracton, based on strong relatonshps between partners and trust. Propertes such as qualty, nnovaton, nformaton sharng, ntensty of collaboraton are n general ntangble or non-contractble and they are crucal for value networks. Ths justfes our focus on modelng networks n an ncomplete contracts framework, and our emphass on analyzng the ncentves to nvest n non-contractbles. A number of mportant research ssues that exstng research answers only partally are: ( The explanaton of the emergence of networks, as opposed to herarches and arm s length markets. ( The desgn and performance dmensons of value networks. How do hub frms (e.g. Csco should desgn ther networks? ( The structure and effects of competton between value networks. Ths paper focuses on the thrd ssue and addresses part of the frst two ssues. We beleve that property rghts arguments that are based on the IC framework and emphasze asset ownershp are promsng n further explanng the emergence of networks. ([7] makes that observaton too, although the paper s crtcal of the IC framework. A crucal aspect of competton between value networks s the creaton of dstnct networks of mportant partners. A sgnfcant drawback of sharng a suppler wth your compettor s the potental msappropraton of nformaton by the suppler. Frms usually deal wth that problem by (a sgnng non-dsclosure agreements for propretary nformaton shared, (b usng frewalls (e.g. the suppler assgns separate teams to work wth each bg buyer. Recent research has ponted to the rsk of nformaton msappropraton (see [8], [9]. Moreover, a suppler that acheves sgnfcant power n the value chan may later on ntegrate forward. Potental benefts from sharng are producton economes of scale, and coordnaton as descrbed n []: Suppose Com, ortel, and Csco were all bddng on a large pece of busness and they all showed a spke n ther demand forecasts on the assumpton they would all wn the busness. If we as a dstrbutor accepted all these forecasts at face value, our numbers would be off. But we know only one of them wll get the sale. So we factor that nformaton nto the data we re gvng to ntegrated crcut manufacturers (Paul Eslng, Avnet parts dstrbutor manager. Ths paper emphaszes that the supplers ncentves to nvest n non-contractbles should also play an mportant role n the manufacturer s decson to share or not to share supplers.. Monopoly value network /5/$. (C 5 IEEE

3 Proceedngs of the 8th Hawa Internatonal Conference on System Scences - 5 [] and [] studed the number of supplers monopoly queston wthn an ncomplete contracts framework. The dscusson n ths secton departs from these papers by makng the end-consumer market explct, and by endogenzng the relatve mportance of nvestments and the opton of not creatng a network. (The relatve mportance of nvestments s typcally exogenous n the IC lterature. It s an mportant concept because the agents that have mportant nvestment decsons should typcally own the assets nvolved. Fgure. Monopoly Value etwork A sgnfcant fndng of [] s that a small-numbers network s preferred, when non-contractble nvestments (e.g. qualty, nnovaton, responsveness, collaboraton ntensty are nvolved, and the relatve mportance of supplers nvestments s sgnfcant for the value created n the network. That dea would be counterntutve n the context of tradtonal compettve analyss, where smallnumbers barganng stuatons are n general negatve for an ncumbent and therefore should be avoded. An mportant mplcaton s that n an ncomplete contracts world, the desgn of the number of supplers by the manufacturer s crucal for the network performance. A smlar dea was proposed n [] as the move to the mddle hypothess. Earler [] artculated the move to the market hypothess facltated by the reducton of coordnaton costs. (See also [4] and [5, 6] for related dscussons based on agency costs and search costs respectvely. The structure of the game we analyze s the followng: Stage : The manufacturer m chooses the optmal number of supplers n, or not to create a network. Stage : If n >, the network partners contract on R (the relatve mportance of nvestments. Stage : The partners nvest n non-contractbles. Stage : The network sells to consumers; the partners bargan (Shapley value on the dstrbuton of proft. The BC market s vertcally dfferentated and the consumers are heterogeneous wth types θ ~ U[,]. For qualty s and prce p the utlty of type θ consumer s U = θts p. The parameter t captures the mportance θ of qualty for end consumers. The monopolst sets a prce to maxmze ts proft and the equlbrum proft s ts Π= (the margnal cost s constant and zero. 4 We now characterze the BB market. Let x nvestment by suppler, and y nvestment by the manufacturer and c (. ncreasng and convex nvestment cost functon (assume quadratc. The FC for nvestments gven the number of supplers are the followng. n c ( x =, c ( y = n n+ x n+ y The optmal number of supplers for the manufacturer max Π nc x c y. s gven by n Let the qualty of the network gven by a b s Rx + ( R x, ab<,. Proposton. When a network s created, the optmal R s ether or close to. That s ether the smallnumbers result holds n the strongest sense (.e. the supplers should have % of the mportance of nvestment or the manufacturer should keep most of the nvestment mportance. The value for the manufacturer from no network s a a a V = a a. The max value of the network as a functon of the relatve mportance s ether b b n( n+ ( + V = n n n b a a a an an V ( lmv =, where n s R n+ n+ the optmal number of supplers n each case. There mght be a regon of R values for whch not creatng a network s optmal for the manufacturer. Proposton. A network s created ff V < max V (, V. The optmal number of supplers for the network s the respectve n of the V V. max, The above condtons can be generalzed for ncreasng and concave network qualty functons and ncreasng and convex costs of qualty. or /5/$. (C 5 IEEE

4 Proceedngs of the 8th Hawa Internatonal Conference on System Scences Value network competton Ths secton defnes the model for the network duopoly case. We analyze the followng game structure. Stage : Each manufacturer chooses a network,.e. each manufacturer chooses ether ts optmal number of supplers ( 5, or announce ts wllngness to share a suppler wth ts compettor ( 6. Stage : The partners n each network nvest n noncontractbles. Stage : The networks compete n the consumer market; the partners n each network bargan on the dstrbuton of network profts. We wll frst characterze the bc market structure, and then we wll analyze the number of supplers under competton, and the structure of network competton. The BC market structure s a vertcally dfferentated duopoly. The consumer preferences are gven by U = θts p, θ ~ U[,], as n the monopoly case. θ Let manufacturer be the hgh qualty ( s frm and manufacturer be the low qualty ( s frm. The frms compete on prces. The equlbrum prces and profts follow. t( s s ( s + s ts ( s s p =, p = s + s s + s t( s s ( s + s ts s s, ( s + s s + s Π = Π = The partal dervatves we need are the followng: ts ( 4s 6s s s ts 5s s s =, = ( s + s s s + s ( + ( + + t s s s s s s = > ( ( + ( + 5 ( s s + s ts s s s s = < s s + s otce that >, ff s.4s > s 5. The number of supplers., >, ff s < s s + 4 and We now analyze the equlbrum number of supplers queston under competton. Let y, y represent the nvestments of manufacturer and respectvely. Assumng symmetry between the supplers of each manufacturer, let x represent the nvestment of each suppler of manufacturer, and let x represent the nvestment of each suppler of manufacturer. Let c y (., c x (. be ncreasng and convex nvestment cost functons of the manufacturers and the supplers respectvely. The FC for nvestment are: c x ( x, x n n x c x = = + n n + x y n c y = c y =, y n + y n + y * * n The equlbrum number of supplers n, n under competton solves the system: n n max Π n c x c y, x y max Π n c x c y x y We assume that the network s BC qualty s determned by the mnmum of the qualty of the network partners,.e. s mn [ x, y ]. Then a necessary condton for the equlbrum nvestment s that x = y. The reason s that for any nvestment of the one partner, the best response of the other partner s an nvestment level lower or equal. Proposton. The equlbrum number of supplers s * n = λ, where λ = cy x cx ( x and x s the equlbrum nvestment of the partners n network. The number of supplers s senstve to the rato of the margnal nvestment cost functons. When the margnal cost of nvestment of the supplers and a manufacturer s the same, then the equlbrum number of supplers for that network s. IT reduces the cost of nvestment n non-contractbles. The equlbrum number of supplers s senstve to the way IT affects the rato λ, whch n turn depends on the effectveness of use of IT by each partner. For example, a more effectve use by the manufacturer wll decrease λ and that leads to a decrease of the equlbrum number of * supplers n. 6. The structure of value network competton /5/$. (C 5 IEEE 4

5 Proceedngs of the 8th Hawa Internatonal Conference on System Scences - 5 We analyze two network competton structures, a parttoned and an overlappng, and we characterze the equlbrum structure. The parttoned network competton captures a shft of the ndustry structure to competton between whole value networks. Ths shft s depcted as a shft from an ndustry structure as n fg. to and ndustry structure as n fg.. Let x, y nvestments by the suppler and manufacturer respectvely. We assume that all nvestments are % specfc to the relatonshp, so ther value outsde the relatonshp s. We assume frst that only the supplers nvest, therefore s x + s, where s (not large s a baselne qualty level that both manufacturers can offer ndependent of the suppler nvestments. Let c( x an ncreasng and convex nvestment cost functon and F a fxed cost ncurred by each suppler. 6.. Parttoned network competton ( + ( s +.87t.48 s.58t t Π = ( + ( s +.87t =Π = ( ( s +.87t =Π = (.4 s +.59 s t +.9t ( s +.87t.48 s.565t t Π = P V P V x x F, s s t t t F F F 6.. verlappng network competton Fgure. Parttoned network competton structure The nvestment condtons are the followng. = = x x, c x c x = = y y, c y c y When only the supplers nvest, the equlbrum nvestments are ( x, x = (.58 t,.6t. Therefore the equlbrum network profts and the total value captured by each network are as follows: Fgure. verlappng network competton structure The nvestment condtons are the followng: c ( x = B + B, c ( x = B + B, x x x x =, = = / c y B c y B, B y y When only the suppler nvests, the equlbrum t nvestments are ( x, x =,. Therefore the 8 equlbrum network profts and the total value captured by each network are the followng: /5/$. (C 5 IEEE 5

6 Proceedngs of the 8th Hawa Internatonal Conference on System Scences - 5 ( 6s + t t s Π =, Π = V V = = t s + t s + t F s t F Π x =, ( s + t ( F s st t t F 8 Π x = ( s + t V - V P t=6< 8t=, t=, t=4, s 6.. Equlbrum competton structure The overlappng network competton structure s an equlbrum ndustry structure when both manufactures, are wllng to share supplers. We compare the value of each network under the two equlbrum structures analyzed n 6. and 6.. The manufacturer (the hgh qualty manufacturer P always prefers the sharng of supplers, snce V > V. However, the low qualty manufacturer prefers to share supplers only when the followng expresson s postve: P V V = 4 ( s t + s t s t s t 6 t 4 5 F ( s + t ( s + t The man proposton follows: Proposton 4. The equlbrum ndustry structure shfts to competton between whole value networks when qualty s mportant for end-consumers ( t s large, the baselne consumer market qualty s s not large, and the suppler fxed cost F s not large. The ntuton of that result s the followng. The beneft of both manufacturers from sharng supplers derves from sharng the suppler fxed cost F (each network F ncurs. However, a shared suppler has weak ncentves to nvest n non-contractbles for the low qualty manufacturer. That reduces the value that the low qualty network captures, and ncreases the value that the hgh qualty network captures. Therefore, the shft n ndustry structure s determned by the trade-off that the low qualty manufacturer faces. When qualty s mportant for end consumers and the suppler fxed cost s not large then the low qualty manufacturer s better off by not sharng supplers. The followng fgure shows the ndustry shft to competton between whole value networks, as the mportance of qualty for end consumers ncreases (the P shft happens when V V <. Fgure 4. The effect of ncreasng the mportance of qualty for end consumers (assume F= The crucal drver of proposton 4 s the mportance of non-contractbles and the ncentves to nvest n noncontractbles n network settngs. Consder the ncentves of a shared suppler to nvest n non-contractbles for the low qualty network. The ncentves are determned by the nvestment condton c ( x = +. x x From secton 4 we know that the frst partal ( x s postve and the second partal s negatve. An x nvestment n non-contractbles for network, ncreases margnally the proft of network, but decreases the proft of network (ths happens because competton s more ntense n the consumer market. However, for any gven s the negatve effect domnates: ( + + x x x x x + = < x x x + x ( Therefore, the shared suppler s not wllng to nvest n non-contractbles for the low qualty network. We would expect a trend toward competton between whole value networks n ndustres where noncontractbles become more mportant for end-consumers. We hypothesze that ths mght be an explanaton of the shft toward competton between value networks clamed n several busness press artcles. However, n ndustres where non-contractbles become less mportant we mght see an overlappng network competton structure, whch acheves sgnfcant economes of scale through sharng of the suppler fxed costs The effects of IT IT can be a crucal enabler of the ndustry shft through two effects: (a IT can enable the redefnton of consumer /5/$. (C 5 IEEE 6

7 Proceedngs of the 8th Hawa Internatonal Conference on System Scences - 5 preferences n certan consumer markets, and (b IT reduces the costs of nvestment n non-contractbles. The frst IT effect s a demand sde effect. The heavy use of IT to customze products and servces, create new products or bundle products wth more nformaton content and new servces, may redefne the consumer preferences ncreasng the mportance of qualty for end consumers. Ths enables a shft to competton between whole value networks. Evdently, other exogenous factors such as the ncome ncrease can make the qualty more mportant. The second IT effect s a supply sde effect. IT reduces the costs of sharng nformaton, enables rcher collaboraton and coordnaton between partners. IT can ncrease the responsveness, tmelness and qualty of BB processes. As a result IT reduces the costs of nvestment n non-contractbles. That effect ncreases P P V, V, V, but t decreases V. As a result t expands P the area n whch the condton V V < s true, and makes the shft of ndustry structure more lkely. The ntuton of that result s the followng. The reducton of the cost of nvestment n non-contractbles does not affect the weak ncentve of a shared suppler to nvest n the low qualty network, therefore V cannot ncrease. At the same tme, the cost reducton ncreases the nvestment ncentves n all the other cases (ncreases P P P P x, x, x leadng to an overall ncrease of V, V, V and a decrease of V. The followng fgure shows the shft to competton between value networks. IT reduces the cost of nvestment n non-contractbles and the P V V < regon expands. a=< V - V P 8a=6, a=4, a=, a=, s Fgure 5. The effect of reducng the cost of noncontractbles ( c( x = x, t =, F = a We beleve that ths process enabled by the reducton of the cost of non-contractbles due to IT s a crucal aspect of the shft of ndustry structures to competton between whole value networks. 7. Concludng remarks Ths paper has been motvated by the emergence of value networks as a new form of ndustral organzaton, and the conjecture of busness observers that a shft to competton between whole value networks s underway n many ndustres. We developed a model that characterzes a number of desgn aspects of value networks such as the number of supplers and the relatve mportance of partner nvestments. We analyzed the condtons that may enable a shft of ndustry structure and we showed that IT plays a crucal role n that shft. ne paper extenson we are currently examnng, s to analyze how flexble suppler technologes that ncrease the transferablty of nvestments across networks affect the structure of network competton. Prelmnary results show that flexble nvestments may further favor a shft to competton between whole value networks. Another extenson s a settng where the nvestment of partners contrbutes to horzontal rather than vertcal dfferentaton of the networks. That wll enable us to understand better the competton between value networks and the role of IT n ndustres where horzontal dfferentaton s the domnant end-consumer feature. Thus, our theory wll become more comprehensve. The theory can be tested by collectng data on the structure of value chans n dfferent ndustres and ther evoluton over tme. There are two core questons: ( Dd the ndustry structure shft to competton between whole value networks n ndustres where qualty has become more mportant? ( Can we correlate structural dfferences n dfferent ndustres wth the level of IT nvestment? Does hgher IT nvestment s postvely related to the shft to competton between whole value networks? There s clearly a need for more research n the emergence of value networks, ther desgn features and ther performance and the crucal role of IT n that new governance structure. References [] D. Tapscott, D. Tcoll, and A. Lowy, Dgtal Captal: Harnessng the Power of Busness Webs: Harvard Busness School Press,. [] D. Tapscott, "Rethnkng strategy n a networked world," n Strategy & Busness,, pp. -8. [] K. Bren, "Value chan report: the connected economy," n IndustryWeek.com,. [4] C. Benko and W. McFarlan, "Connectng the dots," n CSC World, vol., 4, pp /5/$. (C 5 IEEE 7

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