DP2558 Idiosyncratic Investments, Outside Opportunities and the Boundaries of the Firm

Author(s): Rudolf Kerschbamer, Nina Maderner, Yanni Tournas
Publication Date: September 2000
Keyword(s): Boundary Choice, Incomplete Contracts, Relation-Specific Investment, Transaction Costs
JEL(s): C23, L14, L22, L23
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=2558

This paper adopts the incomplete contracting perspective to study a firm’s continuous choice between producing an essential input in-house (full integration), contracting part of the production out (tapered integration), and contracting all of the production out (non-integration), when (i) an idiosyncratic capacity investment is required to produce the essential input and (ii) under non-integration, outside opportunities are better. We show that the firm’s boundary choice depends crucially on its commitment power. If the firm can pre-commit to a particular provision mode, tapered integration will be chosen more frequently. Also, with commitment power the firm will never subcontract only a small portion of its input needs. In-house capacity is in general smaller and outside capacity larger if the firm can pre-commit. Total capacity is never larger in the commitment than the non-commitment case.