Integration versus Outsourcing in Industry Equilibrium Gene Grossman and Elhanan Helpman Presented by Román Fossati Universidad Carlos III

November 2010

Fossati Román (Universidad Carlos III) Integration versus Outsourcing in Industry Equilibrium

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Introduction Relevant Question What are the determinants of …rm’s mode of organization (VI vs O)? Motivation and Related Literature Empirical evidence: sometimes Outsourcing (O) is more prevalent than vertical integration (VI), and sometimes VI: It di¤er across industries, Helper (1991): documented pervasive O of U.S. automotive parts industry Within industries across regions, Chinitz (1961): …rms in Pittsburgh typically engage in a wider range of activities than similar …rms in New York electronics ind.: greater prevalence of VI in Japan and Korea than in US It also evolves over time: Abraham and Taylor (1996): O of business services in 13 U. S. industries has increased in recent years Campa and Goldberg (1997) and Hummels, Rapoport, and Yi (1998): growth in international outsourcing Fossati Román (Universidad Carlos III) Integration versus Outsourcing in Industry Equilibrium

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Introduction and objectives of the paper Related Literature Previous literature (Williamson 1975, 1985 and Grossman and Hart 1986) focused on bilateral relationship emphasizing the role of transactions costs, asset speci…city, and incomplete contracts on a …rm’s choice of make-or-buy decision)it provides only a starting point for understanding cross-sectional (regional) di¤erences in outsourcing behavior or for recent trends, no interdependence among …rms i.e.: the attractiveness of O to a certain producer may depend on how many …rms potentially can provide the inputs, which may depend on whether rivals in the same industry have chosen VI or O

The present paper Develops an industry equilibrium model of monopolistic competition with search frictions where the vertical structure (O, VI) of …rms is endogenous. In this environment, they study the determinants of the equilibrium mode of organization when inputs are fully or partially specialized Fossati Román (Universidad Carlos III) Integration versus Outsourcing in Industry Equilibrium

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Introduction The insight Production of each variety of a di¤erentiated products requires a specialized component produced either by VI …rms or by pairs of specialized …rms (S,M): They emphasize a trade-o¤ between the 2 modes of organization: VI …rms face a relatively high cost of governance Specialized …rms can produce at lower cost, but there are search frictions (costly search with uncertain success) imperfect contracting (input suppliers face a potential holdup problem)S tries to provide M with incentives to produce inputs to its speci…cations -quality and quantity-) They characterize the equilibrium modes of organization and identify the industry conditions (e¢ ciency of the search technology, the degree of product substitutability, distribution of bargaining power) that support VI or O as the equilibrium outcomes. Fossati Román (Universidad Carlos III) Integration versus Outsourcing in Industry Equilibrium

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Model: Economic Environment Consumers The representative consumer (9 unit measure of consumers) maximizes J

ut =

2N

∑ µj log() 4

j =1

)demand function

Z 0

3 α1

j

j

yj (i ) di 5

yj (i ) = Aj pj (i )

αj

1 1 αj

J

with

where Aj =

∑ µj = 1, αj 2 (0, 1)

j =1

µj E

RNj

pj (i )

αj 1 αj

di

0

E aggregate spending

the unique supplier of variety i in industry j treats Aj as a constant)perceives a constant elasticity of demand σ = 1 1α . j

Fossati Román (Universidad Carlos III) Integration versus Outsourcing in Industry Equilibrium

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Model: Economic Environment Firms technology Production of 1 unit of any …nal good requires 1 unit of a high quality input that is speci…c to a product variety (0 outside option for S,M) Final goods may be produced by VI …rms λj 1 units of labor are required to produce 1 unit of the (high quality) input (VI …rm not specialized+cost of managing a larger …rm) kjv …xed production cost Specialized producers (S) purchase inputs from specialized suppliers (M) S must search for a M (random matching): n(r ) 2 h1 ) εn < 1, r = m/s M can produce a high quality input (1 u of labor per u of output), or a low quality (useless) input at some lower cost kjs + kjm …xed production cost (kjs + kjm
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Model Timing Firms play a game with the following 5 stages: 1) Entry)a portion of the …xed costs are incurred 2) Search)the remaining …xed costs are incurred and …rms that do not …nd partners exit the market 3) Production of intermediate inputs 4) Bargaining (NBS) over revenues (ω share of revenues goes to supplier) 5) Production and sale of …nal goods. Fossati Román (Universidad Carlos III) Integration versus Outsourcing in Industry Equilibrium

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Model: Pair of producers (O) After a match takes place, if M produces xi units) S able to produce yi units Then two …rms to negotiate (all costs are sunk) over potential revenue pi xi Before that the supplier decide how much to produce and the quality

maxfmax ωpi xi xi

xi , 0g

)the supplier choose to produce high quality and set α xi = yi = A(αω ) 1 α )Final good producer set price and production α 1 ps = ys = A(αω ) 1 α given demand function αω Pro…ts

= η (r )(1

α

ω )A(αω ) 1 α ks α η (r ) π m = (1 α ) ωA(αω ) 1 α km r Fossati Románan(Universidad III) Integration versusEOutsourcing Industry Equilibrium 2010 " the 8 / 18 Given industry Carlos demand level A) (π ) "inthe larger is the mNovember (because πs

Model: VI producer A VI …rm faces a marginal production cost λ and a demand curve given by

yj (i ) = Aj pj (i )

pv πv

1 1 αj

)

λ (markup pricing), α λ 1 = (1 α)A( ) 1 α kv α

=

λ 1 yv = A( ) 1 α α

Free entry Expected pro…ts are zero for any type of …rm that enters in positive number)aggregate income (spending)=aggregate wage bill L. Given the de…nition of Aj and pricing equations)the industry demand level is given by

A=

µL α v ( λα ) 1 α

+ sη (r )(αω ) 1

α α

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Types of Equilibria Three types of outcomes may characterize the organization of …rms: Firms may all be VI may all be S producers, or VI and S …rms may compete in the same industry Let’s identify conditions under which there is a stable industry equilibrium with pervasive VI, O, or VI and O

Mixed Equilibria For this outcome there must be positive values of v , s, m s.t. E (π ) = 0

r0 = A0 =

ω (1 α) ks 1 ω km α (αω ) 1 α km r0 ω (1 α) η (r0 ) α

AI

=

( λα ) 1 α km kv (1 α )

Fossati Román (Universidad Carlos III) Integration versus Outsourcing in Industry Equilibrium

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Types of Equilibria Mixed Equilibria Combinations of entrants s and v consistent with E (π ) = 0, when S,M enter in the ratio r0 are given by α α α µL v ( ) 1 α +sη (r 0 )(αω ) 1 α = λ A

if A = A0 ) OO; if A = AI ) VV

Proposition 1: Generically, no industry has both VI and S producers Fossati Román (Universidad Carlos III) Integration versus Outsourcing in Industry Equilibrium

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Types of Equilibria Vertical Integration Proposition 2: There always exists an equilibrium with VI which is stable i¤

AI < A0 When all …rms are VI)a standard situation of monopolistic competition. Free entry implies π = 0, which means that AI with m = s = 0 which imply:

vI =

[(1

α)µL] kv

Fossati Román (Universidad Carlos III) Integration versus Outsourcing in Industry Equilibrium

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Types of Equilibria Outsourcing Proposition 3: There always exists an equilibrium with O i¤ AI stable if AI > A0 . Pervasive O requires that r = r0 , A = A0 v = 0 )

s0 =

[(1

ω )µL] ks

and

m0 =

[(1

A0 which is

α)ωµL] km

Equilibrium mode of organization As we have seen, factors that favor outsourcing are those that increase the ratio: α η (r0 ) kv AI = ω (λω ) 1 α A0 r0 km

where

r0 =

ω (1 α) ks (1 ω ) km

E¤ects of: λ, kv ,e¤ of n (), no e¤ect of (µ, L) Fossati Román (Universidad Carlos III) Integration versus Outsourcing in Industry Equilibrium

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Types of Equilibria Equilibrium mode of organization E¤ects of α: if λω > 1

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Types of Equilibria Equilibrium mode of organization E¤ects of α: if λω < 1 :

AI /AO increases with a i¤ 1

εη >

[log(λω )] (1 α )

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Types of Equilibria Equilibrium mode of organization E¤ects of ω : AI /AO increases with a i¤: εη >

(ω (1

α) α)

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Types of Equilibria Extensions IRS of the matching function: the mode of organization may well depend on market size. Pervasive O is more likely to emerge the higher the market size (increasing the probability of a match and therefore ex-ante expected pro…ts)

Endogenous specialization of inputs The more sensitive are manufacturing costs to the detailed characteristics of the input)the more costly will be the ine¢ ciency arising from partial specialization of components under incomplete contracting. This tends to reduce the viability of outsourcing, but at the same time enhances the bargaining power of each input supplier)makes entry by M more pro…table, and may allow outsourcing to occur more frequently

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Final Remarks The paper provides a simple GE framework for studying the determinants of the equilibrium mode of organization in an environment where a …rm’s market opportunities depend on the organizational choices of others. They focus on the trade-o¤ between the costs from search and incomplete contracts on the one hand and the extra governance costs associated with vertical integration on the other, emphasizing the role of degree of input specialization e¢ ciency of the search technology distribution of bargaining power

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