Asymmetric effects of demand uncertainty on intrafirm trade in durable and non‐durable industries

• Author: Sooyoung Lee
• Date: 01 October 2019
• Published date: 01 October 2019
• DOI: http://doi.org/10.1111/twec.12803

World Econ. 2019;42:3001–3029. wileyonlinelibrary.com/journal/twec

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3001

© 2019 John Wiley & Sons Ltd

Received: 4 June 2017

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Revised: 1 January 2019

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Accepted: 2 April 2019

DOI: 10.1111/twec.12803

ORIGINAL ARTICLE

Asymmetric effects of demand uncertainty on

intrafirm trade in durable and non-durable

industries

SooyoungLee

Korea Institute for International Economic Policy, Sejong‐si, Korea

KEYWORDS

durable, intra‐firm trade, outsourcing, uncertainty, vertical integration

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INTRODUCTION

As Ronald Coase wrote in 1937,1

expecting the future wants of consumers and producing accordingly

before knowing the actual demand is a fundamental problem that firms face. They often need to make

decisions on the quantity and price of their production before they know the market demand. This gap

between production decisions and the realisation of demand affects, among other things, firms' choice

of boundaries, that is, whether to supply intermediate goods from integrated producers (vertical inte-

gration) or in arm's length (outsourcing), because the two choices have trade‐offs in dealing with the

uncertainty.2

This paper investigates the effect of demand uncertainty on firms' choice of vertical in-

tegration versus outsourcing in an open economy.

Uncertainty is, traditionally, a critical dimension to consider when it comes to choose between

outsourcing and integration, but it is more so in the recent years. The demand uncertainty in the past

two decades, measured at the industry level, shows an increasing trend. Figure1 plots two measures

of microeconomic uncertainty: one is measured using the dispersions of sales growth and the other is

measured using plant‐level total factor productivity shocks, which are calculated by Bloom, Floetotto,

Jaimovich, Saporta‐Eksten, and Terry (2018).3

Both measures of microeconomic uncertainty are

steadily increasing. In an uncertain environment, a proper decision of firm boundaries may strongly

1 “The fact of uncertainty means that people have to forecast future wants. Therefore, you get a special class springing up who

direct the activities of others to whom they give guaranteed wages” (Coase, 1937, p. 400).

2 It is important to define the two organisational forms to understand their trade‐offs. I follow the general definitions of

industrial organisation literature: vertical integration means “the unification of control rights” (Gibbons, 2005, p. 203) when a

downstream party owns an upstream party. Outsourcing means when an upstream party supplies intermediate goods under

contract without the ownership or the control of downstream party on the upstream.

3 My use of demand uncertainty is close to the context of microeconomic uncertainty, resulting from the change in prefer-

ences, for example. See Bloom etal. (2018) for more discussions on the concepts and definitions of uncertainty.

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complement the technologies that enable firms to make the supply meet the demand.4

Fisher,

Hammond, Obermeyer, and Raman (1994, p. 84) state that “JIT also may not be feasible if a company

is dependent on an unresponsive supplier for key components” using an example of Dell Computers.

Whether to supply intermediate goods from arm's length or in‐house, therefore, is one of the key

decisions that firms need to make to deal with the increasing demand uncertainty.

The trade‐offs between outsourcing and vertical integration under demand uncertainties are as

follows. Outsourcing requires a contract between two parties, but allows easier entry (with smaller

initial sunk costs) and exit of the market. Real option literature finds that uncertainties make firms

more cautious about future investment (Bloom, Bond, & Van Reenen, 2007; Guiso & Parigi, 1999).

Outsourcing, therefore, is attractive under uncertainty, especially when investment is irreversible and

intermediate goods are customised. Vertical integration offers a secure supply of intermediate goods

free from contractual frictions even when the demand of the final goods or the supply of the inter-

mediate goods undergo shocks. Better management abilities, such as more effective communication

systems and inventory managements, help firms securely supply intermediate goods. The transaction

cost economics (TCE), therefore, claims that vertical integration fares better than arm's length trans-

actions under uncertainty.

4 See Eyob and Tetteh (2012) for more details about the advancements of such technologies from just‐in‐time in earlier years

to the recent global supply‐chain management.

FIGURE 1 Trends of microeconomic uncertainty

Notes: Uncertainty is measured using the standard deviation of the plant‐level sales growth in the black solid line and the

standard deviation of the plant‐level total factor productivity shocks in the grey solid line. The black dashed line is the 5‐year

moving average of sales growth shocks, and the grey dashed line is the 5‐year moving average of productivity shocks.

0.36 0.38 0.4 0.42 0.44 0.46

Productivit

y

shocks

0.18 0.2 0.22 0.24 0.26

Sales growth shocks

1990 1995 2000 2005 2010

Year

Sales growth shocks 5-year moving average

Productivity shocks 5-year moving average