This may be a very basic question.

From a producer's standpoint, what are the theoretical or empirical results on the comparison of cost between buying assembled or full solutions from suppliers vs. buying individual parts from suppliers?

For example, hypothetically speaking, a car manufacturer may choose between multiple assembled braking systems from different suppliers, or, may decide to assemble the system itself and choose between multiple suppliers for each component of the system.

Intuition suggests that buying individual parts and assemble itself has lower cost than buying the full solution even if there are multiple solution providers, as long as the manufacturer has sufficient capacity in assembling. But I wonder if that is the case in every scenario, e.g. in the car manufacturing example above.

  • $\begingroup$ I'm not sure you intuition is correct. Specialization may allow a braking system supplier to offer a lower price than the cost of assembling the unit for the car manufacturer. It would definitely not be the case in every scenario that the firm using the good as an input would be able to produce the good at as low of a cost as the firm which specializes in producing the input good. $\endgroup$ – DornerA Apr 26 '16 at 15:10

Some economists (Oliver Hart and John Moore are among the most prominent) have developed a "theory of the firm" which could help address some of the issues involved. One of the considerations in that theory is that the different parties involved in production can 'hold-up' each other. For example, in this case, the brake manufacturer or the auto manufacturer can suddenly threaten to cancel the relationship with the other party, unless the contract is improved. This, in turn, means they don;t invest much in each other and production is inefficient.

Under that scenario, the optimal solution is for a single party to be the owner of all crucial processes.

This relates to your question in the sense that, from this perspective, the manufacturer is better off buying the individual parts because then it's much harder for anybody to hold it up. Put simply, it has more negotiating power. It will want to in-house processes that are simple, but which could hold it up.

alternatively, it will want to have some serious lawyer power writing the contracts with all its suppliers so that they can't come up with any surprises. That's hard to do. The principle that this is hard to do is called the 'incomplete contracts' principle.

(edits in response to comments:) Other key authors in the theory of the firm are Ronald Coase, Oliver Williamson and Sandy Grossman. For Coase, as long as property rights are well-defined, market allocation would be efficient regardless of who owns what. However, there are transaction costs in markets, maybe you can think of them as contracting or negotiating costs). The firm overcomes the costs of transactions by creating non-market relationships within itself. The boss does not negotiate with the worker every day. This can be more efficient than having all activity being performed in the marketplace.

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  • $\begingroup$ This already good answer could be improved by adding a discussion of Coase's earlier theory of the firm, with the role of search and transaction costs in determining which activities occur in markets and which within firms. $\endgroup$ – BKay Apr 29 '16 at 13:11
  • $\begingroup$ Yes, thank you very much for adding this. $\endgroup$ – Fix.B. Apr 29 '16 at 14:25

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