Managerial Economics and Organizational Architecture, 5e

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.

Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

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

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Managerial Economics and Organizational Architecture, 5e

The Vertical Chain of Production

personal computers
Steps in the vertical chain
1. Raw materials (chemicals, metals,
rubber)
2. Transportation and storage
3. Intermediate-goods processors
(plastics, chips, operating
software)
4. Transportation and storage
5. Assemblers (PC manufacturers)
6. Transportation and storage

Support services

Accounting
Finance
Human resources
Legal
Marketing
Customer support services

7. Retailer distribution and service

(computer stores)
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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

Outsourcing
choosing along a continuum

Spot markets
Purchased at market
price with no longterm commitment

Long-term contracts

Vertical integration
Part or service
produced internally

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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

Competitive Equilibrium
$

LRMC

Price and cost per unit of output

(in dollars)

LRAC

D
Q

i
Quantity of output (firm i)
Firm

Quantity of output
Industry
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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

Firm-Specific Assets
Human asset specificity
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

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Managerial Economics and Organizational Architecture, 5e

Transactions Costs
Measuring quality
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
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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

Using Vertical Integration to

Price Discriminate
Price (in dollars)

200

105

100

Demand

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

55
10

MR
Cancer drug

MC

Demand
MC

10
Q* = 65

MR

Q
170

Pain reliever

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Managerial Economics and Organizational Architecture, 5e

Circumstances Favoring Vertical

Integration
Incomplete contracting
Ownership and investment incentives
Specific assets and hold-up auctions

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Managerial Economics and Organizational Architecture, 5e

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

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Managerial Economics and Organizational Architecture, 5e

Ownership and Investment

Incentives
Vertical integration keeps ownership rights
within the firm

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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

Asset Specificity, Uncertainty,

and the Procurement Decision
Uncertainty
Low

Asset Specificity

Low

Medium

High

Market
transaction

Contract

Contract

Medium

High

Market
transaction

Market
transaction

Contract or
vertical
integration

Contract or
vertical
integration

Contract or
vertical
integration

Vertical
integration
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Managerial Economics and Organizational Architecture, 5e

Circumstances Favoring LongTerm Contracts

Nonspecific assets
Stable environments
Incentive distortions

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Managerial Economics and Organizational Architecture, 5e

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
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Managerial Economics and Organizational Architecture, 5e

Optimal Output in an Example

of the Double Markup Problem
$

Price and cost per automobile

(in dollars)

55,000

P*w =
30,000

5,000

MC
MR
Q* = 250

Quantity of automobiles
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Managerial Economics and Organizational Architecture, 5e

Example of Double Markups

$

$
55,000

Price per unit (in dollars)

55,000

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

P*r =
42,500
P*w =
30,000

5,000

30,000

MR

Q* = 125
275
Quantity
AutoCorp

MC
Q

MC

MR
Q* = 125 275
Quantity

D
550

SUVmart
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Managerial Economics and Organizational Architecture, 5e

Recent Trends in Outsourcing

Global competition
New production technologies
New information communications
technology
Excess capacity

19-24