McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Vertical integration and outsourcing

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The vertical chain of production personal computers

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Vertical chain of production Vertical integration –Forward integration –Backward integration Outsourcing

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Outsourcing choosing along a continuum

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Benefits of competitive market transactions Economies of scale Incentives for efficient production

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Competitive equilibrium

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Reasons for nonmarket transactions Lower nonmarket costs –Firm-specific assets Site specificity Physical asset specificity Human asset specificity Dedicated assets –Measuring quality –Reducing externalities –Extensive coordination

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. More reasons for nonmarket transactions Taxes and regulation Market power Insure input availability

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Using vertical integration to price discriminate

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Asset specificity, uncertainty, and the procurement decision

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Contracting with distributors Free-rider problems –Advertising –Exclusive territories Double markups –Two-part pricing –Quotas Regulatory issues –per se illegal versus rule of reason

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Optimal output in an example of the double markup problem

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Example of double markups

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Recent trends in outsourcing Global competition New production technologies New information communications technology