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The Organization of Supply: a Vertical Equilibrium Analysis

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  • Nadav Levy

Abstract

In this paper I study how the make-or-buy decision of a firm depends on the organization of its peers. I consider a multi-firm framework in which firms choose whether to integrate into the supply of an intermediate input or to outsource its production, and choose the size of their supplier network if outsourcing. Firms find it optimal to share the same set of suppliers, as there are economies of scope in investment to suppliers taking multiple designs. These economies are due to spillovers of technical or operational know-how between projects and to savings in the setup costs on physical capital. The model admits multiple vertical equilibria that are Pareto-ranked, the one with the highest level of outsourcing being most efficient. Outsourcing is more likely in larger markets and when the economies of scope are stronger. The size of the optimal supplier network however typically decreases when the spillovers are stronger. These findings provide insight into the patterns of reorganization of vertical supply relations observed over the last two decades.

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Bibliographic Info

Paper provided by University at Albany, SUNY, Department of Economics in its series Discussion Papers with number 04-01.

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Date of creation: 2004
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Handle: RePEc:nya:albaec:04-01

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Postal: Department of Economics, BA 110 University at Albany State University of New York Albany, NY 12222 U.S.A.
Phone: (518) 442-4735
Fax: (518) 442-4736

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Postal: Department of Economics, BA 110 University at Albany State University of New York Albany, NY 12222 U.S.A.
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Web: http://www.albany.edu/economics/research/workingp/index.shtml

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Keywords: Outsourcing; Vertical Integration; Spillovers; Supply relations;

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  1. Raghuram G. Rajan & Luigi Zingales, 1998. "Power In A Theory Of The Firm," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 113(2), pages 387-432, May.
  2. Thomas J. Holmes, 1995. "Localization of industry and vertical disintegration," Staff Report, Federal Reserve Bank of Minneapolis 190, Federal Reserve Bank of Minneapolis.
  3. Hart, Oliver D. & Moore, John, 1990. "Property Rights and the Nature of the Firm," Scholarly Articles 3448675, Harvard University Department of Economics.
  4. Grossman, Sanford J & Hart, Oliver D, 1986. "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 94(4), pages 691-719, August.
  5. Robert Feenstra, 2003. "Integration Of Trade And Disintegration Of Production In The Global Economy," Working Papers, University of California, Davis, Department of Economics 986, University of California, Davis, Department of Economics.
  6. Abraham, Katharine G & Taylor, Susan K, 1996. "Firms' Use of Outside Contractors: Theory and Evidence," Journal of Labor Economics, University of Chicago Press, University of Chicago Press, vol. 14(3), pages 394-424, July.
  7. George J. Stigler, 1951. "The Division of Labor is Limited by the Extent of the Market," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 59, pages 185.
  8. Gene M. Grossman & Elhanan Helpman, 2002. "Integration Versus Outsourcing In Industry Equilibrium," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 117(1), pages 85-120, February.
  9. J. Yannis Bakos & Erik Brynjolfsson, 1997. "From Vendors to Partners: Information Technology and Incomplete Contracts in Buyer-Supplier Relationships," Working Paper Series, MIT Center for Coordination Science 154, MIT Center for Coordination Science.
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Cited by:
  1. João Teixeira, 2014. "Outsourcing with long term contracts: capital structure and product market competition effects," Review of Quantitative Finance and Accounting, Springer, Springer, vol. 42(2), pages 327-356, February.

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