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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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