Make or buy decisions over upstream and downstream inputs

One of the big questions in the theory of the firm is about determining the boundaries of the firm. This is normally thought about as a "make or buy" decision. That is, firms can vertically integrate, or outsource, upstream and downstream functions. The more functions you do in house, "make", the larger is the firm and the more functions you outsource, "buy", the smaller is the firm. This is true whether or not the firm outsources to firms in their own country or to firms overseas. In fact trade in intermediate inputs now accounts for as much as two-thirds of international trade. Firms must decide which segments of their production processes to own and which to outsource.

A new column, Make or buy decisions over upstream and downstream inputs: An investigation of firm boundaries along value chains by Laura Alfaro, Pol Antràs, Davin Chor and Paola Conconi, at VoxEU.org looks at firms’ organisational choices along value chains. Using global plant-level data, this column empirically examines the organisational choices that firms make along the value chains. Decisions to integrate or outsource upstream and downstream functions are found to depend on demand elasticity relative to the substitutability of inputs. These results provide strong evidence that integration decisions are driven by contractual frictions.

Alfaro, Antràs, Chor and Conconi start by developing a theoretical framework of firm behaviour that is amenable to estimation using firm-level data. They "describe an incomplete-contracts model in which the manufacturing of final goods entails a large number of production stages that need to be performed in a predetermined order. Suppliers provide the different stages by undertaking relationship-specific investments to make their components compatible with those of other suppliers in the value chain". They also "allow for heterogeneity in the importance of inputs for production, as well as in the marginal cost of production faced by suppliers at different points along the value chain".

As to the empirical bits,

To bring the model to the data, we use WorldBase, a comprehensive plant-level dataset that provides information on the activities of firms located in many countries and territories. Plants belonging to the same firm can be linked via information on domestic and global parents using a unique identification number. Our main sample consists of more than 300,000 manufacturing firms in 116 countries. For each plant, WorldBase provides information about its primary production activity and secondary activities. To distinguish between integrated and non-integrated inputs, we combine this information with Input-Output tables [...]. We also use Input-Output tables to construct a new measure of the position of different industries along the value chain. This measure is industry-pair specific and captures the ‘upstreamness’ of each input i in the production of output in sector j. Figure 1 provides an illustration of the variation contained in this measure, when focusing on one particular input industry, Tires and Inner Tubes (SIC 3011). Notice that the upstreamness measure is smaller for industries that use tires almost exclusively as a direct input, such as Mobile Homes (2451), Lawn and Garden Equipment (3524), Industrial Trucks and Tractors (3537), Motorcycles, Bicycles, and Parts (3751), and Transportation Equipment (3799). This new measure is distinct and more informative than the one developed in Antràs et al (2012), which restricted attention to the distance of an input relative to final demand (see the horizontal line in Figure 1 for the case of Tires).

Figure 1. Upstreamness of tires (SIC 3011) in the production of all other manufacturing industries

The richness of our data allows us to exploit variation in the organisation of different firms, as well as within firms across their manufacturing stages. In line with the key prediction of our theoretical model, we find that a firm's propensity to integrate upstream (as opposed to downstream) inputs depends crucially on the relative size of the elasticity of demand for the firm's final good and the elasticity of substitution across its production stages. The higher the demand elasticity faced by the firm relative to the substitutability of its inputs, the more likely it is that the firm will outsource upstream suppliers rather than downstream ones. The intuition for this result is that, when the demand is elastic or inputs are not particularly substitutable, input investments are sequential complements; that is, the marginal incentive of a supplier to undertake relationship-specific investments is higher, the larger are the investments by upstream suppliers. In this case, the firm finds it optimal to contract at arm’s length with upstream suppliers in order to incentivise their investment effort, while integrating the most downstream stages to capture surplus. When demand is inelastic or inputs are sufficiently substitutable, input investments are instead sequential substitutes; that is, investments by upstream suppliers lower the investment incentives of downstream suppliers. When this is the case, the firm chooses to integrate relatively upstream stages, while engaging in outsourcing with downstream suppliers.

Alfaro, Antràs, Chor and Conconi contiue,

We also construct a measure of input contractibility for each SIC industry (following Nunn 2007) and examine how firms' ownership decisions are shaped by the degree of contractibility of upstream versus downstream inputs. We find that a greater degree of contractibility of upstream inputs increases the likelihood that a firm integrates upstream inputs, when the firm faces a high elasticity of demand (both in absolute terms, as well as relative to our proxy for input substitutability). This result is also in line with the predictions of our theoretical model, according to which greater upstream contractibility reduces a firm's need to rely on organisational decisions and arrangements to elicit the right incentives from suppliers positioned at early stages in the value chain.

The firm-level empirical patterns that we uncover in our analysis provide strong evidence that considerations driven by contractual frictions are critical in shaping the integration choices of firms along their value chains.