Chapter 19: Vertical Integration and

Outsourcing

Brickley, Smith, and Zimmerman, Managerial Economics and

Organizational Architecture, 4th ed.

Vertical integration & outsourcingLearning objectives

• Identify the benefits of acquiring inputs or services through competitive markets

• Describe conditions favorable to acquiring services through nonmarket (internal) transactions

• Analyze tradeoffs involved with acquiring inputs through long-term contracts versus vertical integration

• Identify how asset specificity and environment uncertainty affect the vertical integration versus long-term contract decision

The vertical chain of productionpersonal computers

Vertical chain of production

• Vertical integration– Forward integration– Backward integration

• Outsourcing– Spot markets– Contracting

Outsourcingchoosing along a continuum

Purchased at market price with no long-term commitment

Part or service produced internally

Benefits of competitive market transactions

• Economies of scale

• Incentives for efficient production

Reasons for nonmarket (internal) transactions

Lower nonmarket costs• Firm-specific assets

– Site specificity– Physical asset specificity– Human asset specificity– Dedicated assets

• Measuring quality• Reducing externalities• Extensive coordination

More reasons for nonmarket (internal) transactions

• Taxes and regulation– Reduce government intervention

• Market power– Ability to price discriminate

• Insure input availability and quality

Using vertical integration to price discriminate

Vertical integration versus long-term contracts

• Circumstances favoring vertical integration– Incomplete contracting– Ownership and investment incentives– Specific assets and hold-up auctions

• Circumstances favoring long-term contracts– Nonspecific assets– Stable environments– Incentive distortions

Asset specificity, uncertainty, and the procurement decision

Contracting with distributors• Free-rider problems

– Advertising– Exclusive territories

• Double markups– Two-part pricing– Quotas

• Regulatory issues– per se illegal versus rule of reason

Optimal output in an example of the double markup problem

Example of double markups

Recent trends in outsourcing

• Global competition

• New production technologies

• New information communications technology