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

2. 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

3. The vertical chain of production personal computers

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

5. Outsourcing choosing along a continuum
Purchased at market price with no long-term commitment
Part or service produced internally

6. Benefits of competitive market transactions
Economies of scale
Incentives for efficient production

7. 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

8. More reasons for nonmarket (internal) transactions
Taxes and regulation
Reduce government intervention
Market power
Ability to price discriminate
Insure input availability and quality

9. Using vertical integration to price discriminate

10. 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

11. Asset specificity, uncertainty, and the procurement decision

12. Contracting with distributors
Free-rider problems
Advertising
Exclusive territories
Double markups
Two-part pricing
Quotas
Regulatory issues
per se illegal versus rule of reason

13. Optimal output in an example of the double markup problem

14. Example of double markups

15. Recent trends in outsourcing
Global competition
New production technologies
New information communications technology