Chapter 19: Vertical Integration and Outsourcing Brickley, Smith, and Zimmerman, Managerial Economics and Organizational Architecture, 4th ed. Chapter 19: Vertical Integration and Outsourcing

Vertical integration & outsourcing Learning 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 production personal computers

Vertical chain of production Vertical integration Forward integration Backward integration Outsourcing Spot markets Contracting

Outsourcing choosing 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