Outsourcing with long term contracts: capital structure and product market competition effects

Outsourcing with long term contracts: capital structure and product market competition effects This paper analyzes how capital structure and product market competition affect the firms’ strategic choice between outsourcing with long term contracts and outsourcing to the spot market. When outsourcing to the spot market firms are exposed to price uncertainty, whereas a long term contract allows them to set in advance the outsourcing price. We show that, to the extent that leverage and uncertainty can lead to financial distress costs in bad states of nature, firms may use long term contracts as a risk management device to hedge input price uncertainty. With a monopoly in the final product market, the outsourcing decision involves a trade-off between a positive convexity effect of input price uncertainty under the spot regime and the option to avoid financial distress costs under the long term contract regime. Moreover, product market competition among buyers can lead to an increase in financial distress costs not only for firms outsourcing to the spot market but also for firms outsourcing with a long term contract. We examine the monopolist’s outsourcing decision and derive the equilibrium for an oligopoly, and show that the equilibrium depends on the magnitude of these costs and on the level of efficiency of the supplier. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Quantitative Finance and Accounting Springer Journals

Outsourcing with long term contracts: capital structure and product market competition effects

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Publisher
Springer US
Copyright
Copyright © 2013 by Springer Science+Business Media New York
Subject
Economics / Management Science; Finance/Investment/Banking; Accounting/Auditing; Econometrics; Operations Research/Decision Theory
ISSN
0924-865X
eISSN
1573-7179
D.O.I.
10.1007/s11156-013-0344-1
Publisher site
See Article on Publisher Site

Abstract

This paper analyzes how capital structure and product market competition affect the firms’ strategic choice between outsourcing with long term contracts and outsourcing to the spot market. When outsourcing to the spot market firms are exposed to price uncertainty, whereas a long term contract allows them to set in advance the outsourcing price. We show that, to the extent that leverage and uncertainty can lead to financial distress costs in bad states of nature, firms may use long term contracts as a risk management device to hedge input price uncertainty. With a monopoly in the final product market, the outsourcing decision involves a trade-off between a positive convexity effect of input price uncertainty under the spot regime and the option to avoid financial distress costs under the long term contract regime. Moreover, product market competition among buyers can lead to an increase in financial distress costs not only for firms outsourcing to the spot market but also for firms outsourcing with a long term contract. We examine the monopolist’s outsourcing decision and derive the equilibrium for an oligopoly, and show that the equilibrium depends on the magnitude of these costs and on the level of efficiency of the supplier.

Journal

Review of Quantitative Finance and AccountingSpringer Journals

Published: Feb 14, 2013

References

  • How firms should hedge
    Brown, GW; Toft, KB

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