When a firm participates in more than one successive stage of the production or distribution of a product or service, it is said to be vertically integrated. Firms change their degree of integration over time. An organization that begins to produce its own inputs is engaging in backward or upstream integration, whereas an organization that begins to market its own goods or to conduct additional finishing work is engaging in forward or downstreamintegration. The term outsourcing frequently is used to describe a movement away from vertical integration—moving an activity outside the firm that formerly was done within the firm. The term outsourcing also is used to describe an ongoing arrangement where a firm obtains a part or service from an external firm. It is useful to think of the outsourcing decision as a choice along a continuum of possibilities, ranging from spot market transactions to vertical integration with an array of long-term contracts in between.
Well-functioning markets provide powerful incentives for efficient production and low prices; thus, firms acquire many goods and services through market transactions. Economists have identified at least three primary reasons why a firm might want to engage in nonmarket procurement: contracting costs, market power, andtaxes/regulation. Four factors can make the contracting costs of nonmarket procurement lower than the costs of market exchange. These factors include firm-specific assets, costs of measuring quality, externalities, and coordination problems.
Firm-specific assets are assets that are substantially more valuable in their current use than in their next best alternative use. Investment in firm-specific assets can cause enormous problems between suppliers and buyers and is a primary reason for nonmarket transactions. Once the investment in firm-specific assets is made, there is a sunk cost— the supplier has incentives to continue the relationship as long as the variable costs are covered—even if total costs are not. This incentive subjects the supplier to a potential holdup problem. The buyer also can be held up by the supplier. One way of reducing these problems is to integrate vertically. The other method is to negotiate a detailed contract that spells out the rights and responsibilities of each party.
Due to contracting costs, most contracts are incomplete: Many contingencies are unspecified and subject to future negotiation. The prospect of future negotiations can motivate suboptimal investment in both capital and effort. Parties to the contract realize that part of the gains from their investments are likely to go to other parties: They are not protected by a complete contract.
The owner has the right to determine the residual use of an asset—any use that does not conflict with prior contract, custom, or law. Residual rights give an individual increased ability to capture the gains from an investment and thus can provide investment incentives. Vertical integration and long-term contracts differ in their assignment of ownership rights. Vertical integration keeps the ownership rights for the relevant assets within one firm, whereas long-term contracting apportions them between firms. The choice between vertical integration and long-term contracts depends, at least in part, on which ownership structure creates more productive investment decisions.
A primary prediction of the economics literature is that as an asset becomes more firm-specific, the firm is more likely to choose vertical integration over long-term contracting. The analysis suggests that firms will enter long-term contracts when the desired investment is relatively firm-specific and