How Does Outsourcing Affect Performance Over the Product Lifecycle? Evidence from the Auto Industry

This paper examines the impact of vertical integration on the dynamics of performance in the context of automobile product development. Building on recent work in contract theory (Bajari and Tadelis, 2001), we first examine a number of detailed case studies to evaluate the relationship between vertical integration and different performance margins. On the one hand, outsourcing facilitates access to cutting-edge technology and the use of high-powered performance contracts. On the other hand, vertical integration allows firms to respond to adapt to unforeseen contingencies and customer feedback, maintain more balanced incentives over the product lifecycle, and develop firm-specific capabilities over time. Together, these effects suggest that outsourcing will be associated with higher levels of initial performance, while vertical integration will be associated with a higher rate of performance improvement over the product lifecycle. We test these ideas with detailed data from the luxury segment of the global automobile industry. The data combine detailed performance measures over time with nuanced measures of the extent of vertical integration, as well as measures of the contracting and technology environment. Using both OLS and an instrumental variables estimator, we establish four key results. First, initial performance is declining in the level of vertical integration. Second, the level of performance improvement is significantly increasing in the level of vertical integration. Moreover, even after controlling for other factors impacting performance, the magnitude of these two effects are roughly identical – there is no relationship between vertical integration and " overall " performance. Finally, taking advantage of outsourcing during the early part of the product lifecycle and internal development during the latter years of the lifecycle depends on the institutional and strategic environment. For example, the long-term benefits to vertical integration are erased for those firms with a strong union presence. Overall, the empirical findings highlight that vertical integration is associated with both costs and benefits and that different performance margins will reflect the tradeoffs associated alternative contracting modes.