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Chapter 19: Vertical Integration and Outsourcing

Chapter 19: Vertical Integration and Outsourcing. Brickley, Smith, and Zimmerman, Managerial Economics and Organizational Architecture , 4th ed. Vertical integration & outsourcing Learning objectives. Identify the benefits of acquiring inputs or services through competitive markets

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Chapter 19: Vertical Integration and Outsourcing

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

  2. Vertical integration & outsourcingLearning 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 productionpersonal computers

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

  5. Outsourcingchoosing 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) transactionsLower 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

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