Agglomeration, opportunism, and the organization of production

Recent economic analysis of outsourcing has emphasized its international dimension. In contrast, this paper focuses on local outsourcing. The paper specifies and solves a model where the organization of production (vertically integrated or not) and the location of production (agglomerated or not) are jointly determined. The paper shows that agglomeration reduces opportunism, a thick market effect, and so serves as a substitute for integration. This force will lead firms to agglomerate. The paper also shows that the normative properties of equilibrium with local outsourcing are not as clear cut as for international outsourcing. Since local agglomeration is achieved at the cost of congestion, local markets may be too thick, which would not be the case for an increase in the thickness of a world market. Finally, the many changes in economic and social circumstance that have been labeled “globalization” do not impact only vertically integrated firms. They also impact cities and industry clusters to the extent that agglomeration is a substitute for vertical integration.