The internal value chain

If we consider a medium sized or large firm, it is fair to say that the information set on which such firm operates in the market is very large indeed. Classical equilibrium pricing theory suggests that sourcing this information in the open market makes most sense. The transaction costs formalism (Williamson (1975)) (Section 8.11) considers the firm and the market as alternatives for sourcing the vast amount of information the firm needs.

In Section 7.3, we discussed the problems in maintaining and processing of large amounts of information. As the information set becomes progressively larger, the copying fidelity of the information has to increase. This leaves less room for optimization of the operations of the firm by experimentation or error. It also results in inflexibility and little room for adaptation by changing the information set in response to changes in the environment. This problem is clear in many large corporations, particularly also in the development of new products or the development of new businesses. Many large firms observe that venturing firms, small flexible emerging entities, are more successful in developing new businesses in the early stages of development. This is clear in e.g. the pharmaceutical industry, where the advent of genetic engineering in the early seventies of the 20^th century, triggers a number of start-ups that pioneer the development of new pharmaceutical products based on this new emerging technology.

Successful examples are Genentech, Genzyme and Chiron. Ultimately, large pharmaceutical houses, already entrenched in the pharmaceutical industry, acquire or take a controlling interest in many of these companies. Chiron becomes part of Novartis and Roche takes control of Genentech. This illustrates the difficulties in replacing entrenched players in an advanced stage

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of the evolution of an industry.

Many large firms try to resolve such difficulties in coping with radical innovation, by creating internal entities geared towards new business development or, as said, acquire venturing type units. Royal DSM is an example of a company that created an internal venturing unit.

We describe a general solution to the problem of handling large sets of information discussing the Hypercycle in Section 7.4. In essence, the Hypercycle arrangement consists of a number of smaller units that cooperate in a larger functional structure. By splitting the overall information set in smaller pieces that allow more effective experimentation with the information set, a higher ability develops to adapt these sets if the environment so demands. One has to realize that the Hypercycle only works if the units within the cycle cooperate rather than compete. As we discussed, this results if the Hypercycle closes, i.e. if the product of the last information set in the cycle catalyzes the production of the first information set.

Fig 8.4 shows a situation where the activities of the firm split up according to functional departments. This arrangement is one of the common approaches in industrial practice. The functional departments work together in developing, producing and delivering the product to the customer and sourcing information and other resources from the environment. This mitigates the difficulties in managing a very large information set. The information sets of each of the functional units are smaller. This allows more possibilities to fine-tune the sets of the various subunits to the requirements of the environment by experimentation. The arrangement leads to at least the following questions. The firm’s management faces the question, which functions to organize within the Hypercycle that makes up the firm and which functions to source externally.

In the firm, the functional units no longer directly compete with units that have the same function in the outside world. Hence, the inborn optimization of effectiveness that characterizes evolution no longer works. The functional units may be less than optimally effective. Here lies an important task for the overall company management. The advantages of having no transaction costs involved in securing reliable supply of the function must compensate this problem. In addition, the advantages of captive information may be the key differentiating factor. In general, one expects that strategically important functions, of which the information set differentiates the company from its competitors, are not likely to be candidates for outsourcing. Functions necessary to operations of the company, but not differentiating with respect to competing entities, are more likely candidates for outsourcing. However, this distinction between strategic and non-strategic functions is not as straightforward as it seems. As an example, consider the discipline of analysis in industrial R&D. Most of the basic analytical tools are readily available in many institutes or academia. However, using these tools in support of the research activities of a company requires availability of detailed knowledge about the strategic objectives of the research at hand, and requires frequent interaction and sensitive captive knowledge. In such case,

Fig. 8.4. The internal value chain.

103 in house facilities can and will sometimes lead to a decisive competitive advantage. It is one of the many examples where, apart from the basic science, the context in which we deploy the science becomes crucial.

A question that needs an answer relates to the type of action that we need to secure cooperation within the Hypercycle in such a way that it serves the best interests of the company. If we assume that the individuals working in the company are to a certain extent seeking the optimization of their own utility function, working in the best interests of the company is not always likely to occur. Somehow tuning activities in the company to optimize the longer-term profitability of the company needs to take place. The company can achieve this, as an example, by developing a remuneration system that rewards the units according to their contribution to the overall profitability of the company. This is not always easy in a way perceived fair. Units may differ in terms of contribution to long-term versus short-term profitability. Another way in which such coordination can result is if we appeal to so-called altruistic behavior. This develops if the individual players consider it in their best interests to adhere to company goals rather than sub optimization of their narrow minded own interests. The literature argues (Simon, in Dopfer (Ed.) (2005)) that such mechanisms of organizational identification, serve as a mechanism to assure effective coordination.

A further potential problem with a split up of information sets over functional departments within a company rests in handling situations where multidisciplinary decision-making requires inputs from the various functional departments to allow identification of the most adequate actions. Different functional departments tend to speak different “languages” and effective communication is far from trivial. This is notably the case in the formulation of effective overall strategies. Leading firms in the industry spend important efforts in time and money to allow multidisciplinary teams to develop a common picture of reality to assist strategic decision-making.

Another way to cope with internal complexity issues of the firm rests in the creation of divisions or business units. The firm splits up in a way considered the most effective way of organization in view of reducing complexity and problems with the optimization and adaptation of increasingly unwieldy information sets. This splitting process can be of a variety of natures. A split up according to the customer group it serves may be instrumental, e.g. in food and personal care directed units. In addition, a split in terms of products groups, such as Tea, Ice cream, Oils and Fats is a possibility. A split up according to position in the external value chain, i.e. base chemicals, fine chemicals and specialties is another approach. Alternatively, the underlying competences, such as enzyme technology and fermentation technology, can be the organizational principle. In all these cases, splitting up results in coordination problems of the types mentioned above. In addition, the question is whether the synergies involved in having these entities as part of an overall firm lead to preferring this arrangement above sourcing these functions outside the firm. The synergies in having the products and the required competences internally have to outweigh the costs of complexity and the problems of coordinating diverse information sets. In this respect, the food industry witnessed an increasing tendency of organizing ingredient supply in firms other than the companies operating in the consumer products markets.

8.7. Macroeconomics.

Macroeconomics considers the economic system at a level of aggregation of a region, a country or even the whole world. Macroeconomics comes close to the subject matter of this book. It is important to the question how the results of analysis at the microeconomic level, i.e. at the level of markets and firms, serve to direct the evolution of economies in a socially beneficial and orderly way. Macroeconomics studies indicators such as the Gross Domestic Product (GDP), unemployment rates, national income, consumption, inflation, interest rates,

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savings, investments (both public and private), innovation (again also at the aggregated industrial level and public through academia and public institutes), taxes, etc..

Macroeconomics is a broad field of study. A number of aspects that are prominent in the discipline bear a close relation to our field of study. These notably are the business cycles and the drivers of economic growth.

The business cycle theory studies the more or less periodic mid and long-term fluctuations in the economic activity. We analyze some aspects of these issues later in this chapter.

Macroeconomics introduces mathematical models used in economic forecasting by governments and large corporations to facilitate the development of economic policy and (corporate) strategy respectively. Different schools exist that advocate different approaches.

The Keynesian tradition focuses on demand and aims to devise policies to influence the level of unemployment and to mitigate business cycle type of fluctuations in the economy. It calls for an active role of governments and their institutions. Main instruments are fiscal policies that allow governments to invest anti-cyclically to stimulate or cool down the economy. The general Keynesian approach, also the more recent New Keynesianism, focuses on demand stimulation to mitigate what they consider imperfections in the workings of the free market.

The advent of the financial crisis recently caused a revival of the Keynesian approach with, at least to date, some degree of success. The Neoclassical school bases its approach on attempting a synthesis with less emphasis on government spending and a larger role for monetary policy such as managing the rate of growth of money supply and the interest rate.