Make and Buy: Outsourcing, Vertical Integration, and Cost Reduction

Abstract

Globalization reshaped supply chains and the boundaries of firms in favor of outsourcing. Now, even vertically integrated firms procure substantially from external suppliers. To study procurement and the structure of firms in this reshaped economy, we analyze a model in which integration grants a downstream customer the option to source internally. Integration is advantageous because it allows the customer to avoid paying markups sometimes, but disadvantageous because it discourages investments in cost reduction by independent suppliers. The investment-discouragement effect more likely outweighs the markup-avoidance effect if the upstream market is more competitive, as is so in a more global economy. (JEL D21, D24, D25, G31, L14, L22, L24)