Cost Structure, Market Structure and Outsourcing

A partial equilibrium model is developed to investigate the interplay of production technology and the difference of market structure between upstream and downstream markets on firms’ outsourcing choice. It is found that whether outsourcing or vertical integration emerges as the optimal organizational structure depends not only on the cost structure of competing upstream firms, but also on the difference between the “thickness” of upstream and downstream markets. In industries where there are more (less) downstream firms than upstream suppliers, outsourcing is the optimal organization if and only if the upstream suppliers’ technology exhibits economies (diseconomies) of scale. When the upstream firms experience constant return to scale, vertical integration is the optimal strategy, irrespective of the number of upstream and downstream firms. Using firm level data from the German cost structure survey over the period 1992 to 2001, we implement the above model by estimating a set of reduced-form equations. The empirical evidence supports the prediction of the theoretical model. JEL Classification: L22, L60