1. Managerial Economics and Organizational Architecture, 5e Chapter 19: Vertical Integration and Outsourcing
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2. Vertical Integration
Firms must identify the costs and benefits of acquiring inputs or services through competitive markets versus producing them internally
Some activities are better outsourced than others
Tradeoffs are involved with acquiring inputs through long-term contracts versus vertical integration
19-2

3. The Vertical Chain
Inputs flow downstream from raw materials to finished goods
Vertical integration occurs when a firm participates in more than one successive stage of the vertical chain
19-3

4. The Vertical Chain of Production personal computers
Steps in the vertical chain
Support services
Raw materials (chemicals, metals, rubber)
Transportation and storage
Intermediate-goods processors (plastics, chips, operating software)
Assemblers (PC manufacturers)
Retailer distribution and service (computer stores)
Accounting
Finance
Human resources
Legal
Marketing
Customer support services
19-4

5. Vertical Chain of Production
Forward integration
Forward integration occurs when a firm moves into distribution or additional finishing work
Backward integration
Backward integration occurs when a firm begins to produce its own inputs
Outsourcing
Movement away from vertical integration
Spot markets
Contracting
19-5

6. Outsourcing choosing along a continuum
Spot markets
Long-term contracts
Vertical integration
Purchased at market price with no long-term commitment
Part or service produced internally
19-6

7. Benefits of Buying in Competitive Markets
Economies of scale
If the firm does not use sufficient volume to reach economies of scale, the market will be able to produce the input at a lower average cost
Incentives for efficient production
Motivating internal suppliers to produce efficiently is more difficult because market force are not at play
19-7

8. Competitive Equilibrium$
LRMC $
LRAC S
Price and cost per unit of output (in dollars) D Q i
Quantity of output (firm i)
Quantity of output
Firm
Industry
19-8

9. Reasons for Nonmarket Transactions
Why not use the market for all transactions?
Transactions costs
Costs of searching for a supplier, negotiating prices, and enforcing contracts
Some inputs can be produced at a lower overall cost because of high transactions costs
19-9

10. Firm-Specific Assets
Assets that have substantially greater value in their specific use, but not much value outside of the firm
Site specificity
Asset located in a specific area is useful only to producers in that area
Physical asset specificity
Product design makes the asset useful to only a few buyers – specialized tool
19-10

11. Firm-Specific Assets Human asset specificity Dedicated assets
Specialized knowledge on the part of the parties is required to complete the transaction
Dedicated assets
Facilities must be expanded because of the requirements of a specific buyer
19-11

12. Transactions Costs Measuring quality Reducing externalities
Market firms may have an incentive to provide lower quality inputs
Reducing externalities
If reputation is important, outside distributors may have an incentive to free ride on the quality of the products they distribute
Extensive coordination
If timing or fit are important, the costs of contracting will increase
19-12

13. More Reasons for Nonmarket Transactions
Taxes and regulation
May be able to shift profits from a high taxed firm to a lower taxed unit
Market power
If the input is used in two different markets, price discrimination may not work if resell cannot be stopped
19-13

14. Using Vertical Integration to Price Discriminate$ $
The pain reliever
firm may arbitrage with
the cancer firm. By forward
integrating into pain
relievers, the seller
can charge the cancer
drug firms $105
200
Price (in dollars)
105
100
Demand 55
Demand MC 10 MC 10 MR Q MR Q
Q* = 65
170
Cancer drug
Pain reliever
19-14

15. Circumstances Favoring Vertical Integration
Incomplete contracting
Ownership and investment incentives
Specific assets and hold-up auctions
19-15

16. Incomplete Contracting
It is difficult to specify all rights and responsibilities
Not all contingencies will be covered
Costs of contracting will increase
19-16

17. Ownership and Investment Incentives
Vertical integration keeps ownership rights within the firm
19-17

18. Specific Assets and Hold-Up
If the input producer invests in a specific asset, the purchaser may take advantage of this investment (holdup)
To avoid holdup more complete contracts must be written
Costs will increase
As the asset becomes more specific, vertical integration is preferred
19-18

19. Asset Specificity, Uncertainty, and the Procurement Decision
Low
Medium
High
Market transaction
Market transaction
Market transaction
Low
Contract or vertical integration
Contract or vertical integration
Medium
Contract
Asset Specificity
Contract or vertical integration
Vertical integration
High
Contract
19-19

20. Circumstances Favoring Long-Term Contracts
Nonspecific assets
Stable environments
Incentive distortions
19-20

21. Contracting with Distributors
To avoid free-rider problems
Charge franchisees for advertising
Give them exclusive territories
Double markups
Exclusive territories may result in double markup
Combined profits will be lower
Requiring a purchase quota may avoid this problem
19-21

22. Optimal Output in an Example of the Double Markup Problem$
55,000
Price and cost per automobile (in dollars)
P*w = 30,000
5,000 MC MR D Q
Q* = 250
Quantity of automobiles
19-22

23. Example of Double Markups
SUVmart uses $30,000 as their MC
and this results in them raising
prices even further and selling
less than the optimal number of
units $ $
55,000
55,000
P*r = 42,500
P*w = 30,000
30,000 MC
Price per unit (in dollars) MC
5,000 MR D MR D Q Q
Q* = 125
275
Q* = 125
275
550
Quantity
Quantity
AutoCorp
SUVmart
19-23

24. Recent Trends in Outsourcing
Global competition
New production technologies
New information communications technology
Excess capacity
19-24