Idiosyncratic Investments, Outside Opportunities and the Boundaries of the Firm

This paper adopts the incomplete contracting perspective to study a firm's continuous choice between producing an essential input in-house (full integration), buying it from an outside supplier (non-integration) and doing a combination of both (tapered integration), when (i) an idiosyncratic capacity investment is required to produce the essential input and (ii) under non-integration outside opportunities are better. It is shown that the firm's boundary choice de-pends crucially on its commitment power. If the firm can precommit 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 smaller and outside capacity larger if the firm can precommit. Total capacity is never larger in the commitment than in the non-commitment case