Make-or-Buy Decisions: A New Institutional Economics Approach

Abstract

The problem: make versus buy Goods and services are produced through a sequence of activities depicted by the vertical chain of production. For example, at the top of the vertical chain for automobiles are the raw materials, such as plastics, aluminum, steel, rubber, and so on. These inputs are carried to firms which produce the intermediate parts that are used in the final construction of automobiles, such as the chassis, frames, dashboards, cover for seats, and other parts. These intermediate goods are, in turn, assembled into systems. For example, seat systems may incorporate frames, levers, springs, padding, cover, and so on. The intermediate goods are transported to companies which assemble them into cars. Finally, the automobiles are transported to car dealerships, which sell them to customers and provide after-sales services. When a firm participates in more than one stage in the vertical chain of production it is said to be “vertically integrated.” Firms may have different degrees of vertical integration. For example, in the automobile industry, at one theoretical extreme, a fully vertical integrated car manufacturer would own mines from which to obtain raw materials, rubber plantations, tire plants, plastics factories, mills to produce steel and aluminum, spare parts factories, car dealerships, and so on, providing the facilities for operations from digging the raw materials to the final distribution of cars.