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Chapter 19: Vertical Integration and
Outsourcing
Brickley, Smith, and Zimmerman, Managerial Economics and
Organizational Architecture, 4th ed.
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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
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The vertical chain of productionpersonal computers
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Vertical chain of production
• Vertical integration– Forward integration– Backward integration
• Outsourcing– Spot markets– Contracting
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Outsourcingchoosing along a continuum
Purchased at market price with no long-term commitment
Part or service produced internally
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Benefits of competitive market transactions
• Economies of scale
• Incentives for efficient production
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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
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More reasons for nonmarket (internal) transactions
• Taxes and regulation– Reduce government intervention
• Market power– Ability to price discriminate
• Insure input availability and quality
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Using vertical integration to price discriminate
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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
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Asset specificity, uncertainty, and the procurement decision
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Contracting with distributors• Free-rider problems
– Advertising– Exclusive territories
• Double markups– Two-part pricing– Quotas
• Regulatory issues– per se illegal versus rule of reason
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Optimal output in an example of the double markup problem
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Example of double markups
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Recent trends in outsourcing
• Global competition
• New production technologies
• New information communications technology