Outsourcing versus vertical integration: Ethier–Markusen meets the property‐rights approach

Early analyses of direct investment versus outsourcing focused on the existence of knowledge‐based assets, knowledge being non‐rivaled and non‐excludable. Ethier was the first to formally model the consequences of non‐excludability for the vertical integration versus outsourcing decision. Later authors took a different approach, modeling physical capital as fully excludable but relationship‐specific. This paper further develops a model with both non‐excludable knowledge capital and fully excludable physical capital. Results show that vertical integration tends to be chosen when (a) the technology is relatively knowledge intensive and/or when (b) knowledge and physical capital are strong complements.