Outsourcing versus Vertical Integration: A Dynamic Model of Industry Equilibrium

Empirical evidence shows that vertically integrated producers are more productive, bigger and are matched to better suppliers (with high productivity and size). I present a dynamic stochastic model of an industry with heterogeneous firms interacting as buyers and sellers, and market frictions that induce a hold-up problem to the manufacturers to account for these facts. In the model economy, an industrial structure emerges as the result of optimal investment decisions that firms undertake under uncertainty. Firms choose whether to integrate, link to external sellers or buy inputs in the market. This theoretical environment provides a natural framework to answer several questions: Why do supply relations vary across industries and across firms within industries? Why aren't all large firms vertically integrated? How do changes in the properties of uncertainty at firm level determine differences in the vertical structure of an industry? We find that higher uncertainty is associated with higher likelihood of outsourcing; vertically integrated firms are larger and more efficient; otherwise identical downstream firms may differ in their vertical structure, and those that are vertically integrated can end up disintegrated or remain integrated. We also analyze the effects of changes in costs of vertical integration and outsourcing on welfare, aggregate output and productivity.