​Vertical Relations, Demand Risk, and Upstream Concentration: the Case of the US Automobile Industry

This paper studies how upstream market concentration and demand risk affect downstream firms' outsourcing decisions. I formulate a structural model in which outsourcing allows the downstream firms to avoid the uncertain in-house production cost by switching to a stable price and where upstream firms leverage the insurance motive of downstream firms by increasing prices. The model delivers equilibrium outsourcing patterns, as well as equilibrium upstream prices. I estimate the model using data on the vehicle manufacturers and upstream transmission firms in the automobile industry. Facing a negative demand shock equivalent to the recent pandemic, when the upstream firms' prices are fixed, outsourcing from upstream firms mitigates the rise in transmissions' production cost by 48%. Endogenizing upstream’s price response to downstream firms' outsourcing incentives increases their prices by $137.18 (7%). Next, I evaluate the potential impact of the United States-Mexico-Canada Agreement. When the upstream market is more concentrated under the protectionist trade policy, the upstream’s price response to the same pandemic demand shock is 68% larger. It further amplifies the impact of economic downturns on consumer welfare and manufacturers' profit by 65%.