Partial Subcontracting , Monitoring Cost , and Market Structure

We analyze the role of subcontracting in industries where firms utilize their design of organizational production mode as strategic instrument. In particular, we investigate the decision of what fraction of components to produce internally and what fraction to subcontract. In-house production of components is assumed to generate monitoring costs, which increase as a convex function of the number of production lines managed in-house. We characterize the relationship between the equilibrium fraction of subcontracted inputs and the market structure of the final-product market. A monopoly is shown to reduce the fraction of subcontracted inputs compared with the fraction outsourced by competing brand-producing firms. Under duopoly, the outsourcing decisions are found to be strategic substitutes. Finally, we investigate the welfare implications of horizontal mergers under complete and incomplete market coverage.