Integration versus Outsourcing in Industry Equilibrium

TLDR

Differentiated consumer products can be produced by either vertically integrated firms or by pairs of specialized companies, with integrated firms bearing high governance costs and specialized firms enjoying lower production costs but facing search and potential holdup problems. The study develops an equilibrium model of industrial structure with endogenous firm organization and investigates the determinants of the equilibrium mode of organization under full or partial specialization of inputs. The authors construct a theoretical equilibrium model that endogenously determines whether firms integrate or outsource based on input specialization and analyze the resulting organizational outcomes.

Abstract

We develop an equilibrium model of industrial structure in which the organization of firms is endogenous. Differentiated consumer products can be produced either by vertically integrated firms or by pairs of specialized companies. Production of each variety of consumer good requires a specialized component. Vertically integrated firms can manufacture the components they need, but they face a relatively high cost of governance. Specialized firms can produce at lower cost, but search for partners is costly, and input suppliers face a potential holdup problem. We study the determinants of the equilibrium mode of organization when inputs are fully or partially specialized.