vertical integration, Apuntes de Comercio Exterior

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Topic 6

Vertical Integration and

Outsourcing

Contents

1. Vertical Chain of Production2. Reasons for Non-market Transactions3. Vertical integration vs Long-Term contracts4. Contracting with Distributors 5.^ Recent

Trends

in^ Outsourcing

5.^ Recent

Trends

in^ Outsourcing

Company examples•^ Investment in China •^ Du Pont

6.1 Vertical Chain of Production • Firms must identify the costs and benefitsof acquiring inputs or services^ – through transactions in competitive markets(outsourcing) versus^ – producing them internally (in homeproduction) • Some activities are better outsourced thanothers

The Vertical Chain

• Inputs flow downstream from rawmaterials to finished goods• Example. The iPhone economy -

Video

Changes in the Vertical Chain

Outsourcing

choosing along a continuum Spot markets^

Long-term contracts

Vertical integration

Purchased at marketprice with no long-term commitment

Part or serviceproduced internally

Spot markets

Long-term contracts

Vertical integration

6.2 Reasons for Nonmarket Transactions^ • Why activities should be done “in house”?• Why not use always the market?^ –

There exist transaction frictions that are– There exist transaction frictions that are^ not costless (

transaction costs

)

1. Firm-specific assets2. Costs of measuring quality,3. Externalities

Firm-Specific Assets

• Assets that have substantially greater value intheir specific use, but not much value outside ofthe firm• Site specificity^ –^ Asset located in a specific area is useful only to–^ 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 afew buyers – specialized tool • Ex. Personalized investments in machinery,software etc. are very expensive if donethrough the spot market.

Example of Specific Assets – The Hold-Up Problem – The Questions

Other Transactions Costs 2. Measuring quality – It’s difficult to monitor quality on time ->Market firms may have an incentive to cheatand provide lower quality products. Ex. First time exports.time exports. 3. Reducing externalities in distribution – Outside distributors may have an incentive tofree ride on the quality of the products theydistribute relying on the reputation of brand.Ex. Mixing parfum brands in a shop.

6.3 Vertical Integration versus

long-term contracts

• We have discussed reasons why a firmmight acquire a good or service through a^ non
  • market transaction.non-market transaction.
    • We now consider the trade-offs betweenthe two general types of non-markettransactions:^ – Vertical Integration– Long term contracts

Back to “Valles Frens” example

Asset Specificity, Uncertainty,and the Procurement Decision

Uncertainty Low^

Medium^

High

Low Medium Asset Specificity High Markettransaction

Markettransaction Markettransaction Contract Contract

Contract orverticalintegration

Contract orverticalintegration Contract orverticalintegration

Verticalintegration

When Long-Term Contracts are

preferred to“In-house”

• Nonspecific assets. Basic and regularproducts or services. Ex. Cleaning^ services.services. • When there are incentive distortions anddysfunctions within the firm; then the “soft”market discipline of a contract is preferred