A Theory of Modular Production Networks

In many globalized industries, the recent wave of vertical outsourcing seems to have co-evolved with increased horizontal consolidation in the component sector. To account for this phenomenon, I build an industry-equilibrium model in which the boundaries of the firm are endogenous in both the horizontal and vertical dimensions of production. This setup allows me to solve for the equilibrium conditions of four distinct production structures: (1) Vertical Integration; (2) Ideal Outsourcing under which intermediate good firms produce ideal components for final good firms; (3) Standardized Outsourcing under which input providers produce standardized components for multiple final good producers; and (4) Customized Outsourcing under which intermediate good firms produce customized components for multiple final good firms. The concept of product modularity is subsequently introduced into the model. The model demonstrates that product modularization can induce a co-evolution of vertical outsourcing and horizontal consolidation in the component sector through a de facto standardization of inputs and production processes. JEL classification: F23, F12, L22